Analysis of the Impact of Contagion Flow on High Yield Bond Portfolio

Portfolios are constructed to increase returns and manage risk. In high-risk investment strategies, central measures of risk must be complemented with tail measures of risk. An unanticipated event impacting securities of one firm can contagiously affect those of other firms through a contagion flow process. The connections between firms due to a variety of factors can spread the contagion, and potentially impact firms in a network. This can adversely affect the level of tail risk in an investment strategy, especially when a number of these connected firms are included in a portfolio. A model is developed for flow of contagion between firms which will define, characterize and calibrate a contagions impact on default risk of a portfolio of debt instruments. The model assesses the impact of network structure underlying contagion flow and evaluates the contagion related excess risk in a portfolio of high-yield debt instruments.