Analysis of the Impact of Contagion Flow on Firm Value and Application to High Yield Bond Portfolio Optimization

Portfolios of financial instruments are designed to increase returns and manage risk. In high-risk investment strategies, central measures of risk must be complemented with controls on tail measures of risk. An unanticipated event that impacts securities of one firm can contagiously effect those of other firms through a contagion flow process that may occur via a set of network connections. Such connections among firms arise due to a variety of factors, such as a shared supply chain member or auditing firm. These connections spread the contagion, potentially impacting numerous other firms in the network. This can adversely affect the level of tail risk in an investment strategy, especially when many such connected and affected firms are included in a portfolio, such as a bond portfolio.

Reduced form models illustrate how connections between firms can lead to the heavy tailed default distributions seen in empirical data. Historical events help in the understanding of connections that allow contagion to spread between firms. The goal of this research is to combine the insights gained from both previous models and historical events into a structural model for flow of contagion among firms. This includes defining and calibrating contagion variables, including the network that allows the contagion to spread between firms resulting in increased defaults for a portfolio of debt instruments. The model is then utilized to assess the impact of the network structure on the portfolio of high-yield debt instruments. Additionally, simulation data from the model is a key input into a bond optimization used to provide guidance on the immunization of a portfolio of bonds from the impact of contagion flow. Two historical incidences of contagion are presented as test cases to validate the ability of the proposed firm value model including contagion, to alert investors to the impact of a contagion on a bond portfolio.