In order to show how the procedure introduced in the previous chapters works in practice, we now present in some detail the asset allocation produced by the Bayesian net we have discussed in Chapter 16. We have chosen not to deal with a stylized example because we wanted to show the technique at work in a realistic case.

The scenario and the associated Bayesian net

We refer the reader to the detailed description of the scenario and of the associated Bayesian net provided in Chapter 16. For ease of reference we show again the net in Figure 26.1, with some modifications that we explain below.

We have placed ourselves in the shoes of a US$ asset manager who is responsible for a portfolio of UK assets, but who converts all gains and losses into US$.

We have also added a leaf to the net, associated with the ‘market portfolio’, M. This is required because we want to carry out the CAPM-related sanity checks described in Chapter 21 (see Section 21.5 in particular). For the sake of simplicity, the node associated with the market portfolio is assumed to depend directly on the outcome of the Sovereign Crisis (node A), and on whether either a UK or a European bank enters a state of distress (nodes B and C). We associated with the realization M = TRUE the state of the world ‘The market portfolio suffers a significant fall.’ We quantify the magnitude of this fall below.