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Portfolio optimization with a defaultable security

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Author Info

  • Tomasz Bielecki

    ()

  • Inwon Jang

    ()

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    Abstract

    In this paper we derive a closed-form solution for a representative investor who optimally allocates her wealth among the following securities: a credit-risky asset, a default-free bank account, and a stock. Although the inclusion of a credit-related financial product in the portfolio selection is more realistic, no closed-form solutions to date are given in the literature when a recovery value is considered in the event of a default. While most authors have assumed some recovery scheme in their initial model set up, they do not address the portfolio problem with a recovery when a default actually occurs. Given the tractability of the recovery of market value, we solved the optimal portfolio problem for the representative investor whose utility function is a Constant Relative Risk Aversion utility function. We find that the investor will allocate larger fraction of wealth to the defaultable security as long as the default-event risk is priced. These results are very intuitive and reasonable since it indicates that if the default risk premium is not priced properly the investor purchases less defaultable securities. Copyright Springer Science+Business Media, LLC 2006

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    File URL: http://hdl.handle.net/10.1007/s10690-007-9037-x
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    Bibliographic Info

    Article provided by Springer in its journal Asia-Pacific Financial Markets.

    Volume (Year): 13 (2006)
    Issue (Month): 2 (June)
    Pages: 113-127
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    Handle: RePEc:kap:apfinm:v:13:y:2006:i:2:p:113-127

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    Web page: http://springerlink.metapress.com/link.asp?id=102851

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    Related research

    Keywords: Portfolio optimization; Defaultable security; Credit risk; Recovery of market value;

    References

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    1. Antje Berndt & Rohan Douglas & Darrell Duffie & Mark Ferguson & David Schranz, 2005. "Measuring default risk premia from default swap rates and EDFs," BIS Working Papers 173, Bank for International Settlements.
    2. Merton, Robert C., 1973. "On the pricing of corporate debt: the risk structure of interest rates," Working papers 684-73., Massachusetts Institute of Technology (MIT), Sloan School of Management.
    3. Joost Driessen, 2005. "Is Default Event Risk Priced in Corporate Bonds?," Review of Financial Studies, Oxford University Press for Society for Financial Studies, vol. 18(1), pages 165-195.
    4. Robert A. Jarrow & David Lando & Fan Yu, 2005. "Default Risk And Diversification: Theory And Empirical Implications," Mathematical Finance, Wiley Blackwell, vol. 15(1), pages 1-26.
    5. Harrison, J. Michael & Pliska, Stanley R., 1983. "A stochastic calculus model of continuous trading: Complete markets," Stochastic Processes and their Applications, Elsevier, vol. 15(3), pages 313-316, August.
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    Cited by:
    1. Agostino Capponi & Jose Figueroa-Lopez & Jeffrey Nisen, 2011. "Pricing and Semimartingale Representations of Vulnerable Contingent Claims in Regime-Switching Markets," Quantitative Finance Papers 1110.0403, arXiv.org, revised Feb 2012.

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