Faculty of Economics and Business Administration Publications Database

Asset Allocation with Contagion and Explicit Bankruptcy Procedures

Steffensen, Mogens
Volume: 45
Number: 1-2
Pages: 147 - 167
Month: January
ISSN-Print: 0304-4068
Link External Source: Online Version
Year: 2009
Keywords: Portfolio optimization; Liquidation; Reorganization; Default; Finite state Markov chain
Abstract: In this paper, we consider the assetallocation problem of an investor allocating his funds between several corporate bonds and a money market account. In particular, we provide a realistic model of financial distress: firstly, we model Chapter 7 and Chapter 11 bankruptcies as different possible outcomes of financial distress. Secondly, we take into consideration that, in practice, “default” is not the end, but the beginning of financial distress, eventually leading to a reorganization or a liquidation of a distressed firm. Thirdly and most importantly, we are able to analyze the impact of contagion on an investor’s demand for corporate bonds. Contagion is an important phenomenon, as it reduces the investor’s ability to diversify his portfolio, and we show that the bond demand can change by more than 50%.