Multivariate Jump Diffusion Model with Markovian Contagion

Asset prices exhibit characteristics that significantly deviate from log-normality and display time-varying stochastics. There is ample evidence of jumps in one asset price or market leading to jumps in other assets' prices or markets. We propose a multivariate jump diffusion model with Markovian contagion to capture these asset price dynamics, where the channel of contagion is taken to periodically switch from an active to inactive state. We use a dynamic conditional correlation network approach to determine the contagion states and estimate the Markovian contagion model. Applying the model to an international equity and currency portfolio allocation shows the capabilities of the model in capturing fat tail characteristics of asset returns, as well as evaluate the extent of model risk, intra-asset class, inter-asset and inter-region contagion