Decision-Making Under Risk: the Role of Correlation in Fostering the Low-Carbon Transition

An investor building a successful portfolio carefully chooses the financial contracts that best meet her risk profile. The securities that we consider are zero-coupon bonds which are risky since characterized by a certain probability of default. A certain level of correlation between them is present, positive or negative depending on the existing relationship between the firms under analysis. In the work, three parameters (correlation, default probability, and investor’s risk attitude) are leveraged and applied to the complex real economy, under a sustainable finance perspective. The core of the thesis deals with the interplay between defaultable-bond correlation and investors' risk aversion. After the Paris agreement was signed in December 2015, in the risk management environment it has become more evident that climate must be considered assessing the corporate bonds' soundness. The climate risk could result from the sign of a new agreement or the adoption of a climate policy aimed at encouraging sustainable investments. We discover that the correlation can play a crucial role in fostering an endogenous transition to a low-carbon economy, changing the status quo of portfolio management. The impact of a transition on business and portfolio strategy is assessed by a scenario-based approach, exploiting different risk metrics and portfolio selection models (e.g. Markowitz portfolio theory, expected utility maximization, stochastic dominance ordering). In the last part of this work, we adopt the mixture model approach, highlighting its advantages and limits to model the shocks derived by the disorderly introduction of a climate policy, both on bonds’ expected values and on their full probability distributions.