Expected shortfall and portfolio management in contagious markets

For portfolio allocation purposes, neglecting to consider the interdependence of risks embedded in asset returns leads to underestimating the potential of realizing severe losses over short horizons. To address this contagious... [ view full abstract ]

For portfolio allocation purposes, neglecting to consider the interdependence of risks embedded in asset returns leads to underestimating the potential of realizing severe losses over short horizons. To address this contagious risk, we consider a multi-dimensional Hawkes-driven framework where we tackle the problem of minimum loss portfolio allocation, in terms of Expected Shortfall. This is the optimization problem financial institutions face when implementing the capital requirements that are imposed by regulations. We use GMM to estimate the model on three stock indexes (XNG, MSH, BTK) representing three major sectors of the US economy and we perform an extensive out-of-sample back-test.