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Optimal Investment With Default Risk

Author

Listed:
  • Yuanfeng Hou

    (Yale University)

  • Xiangrong Jin

    (FAME and University of Lausanne)

Abstract

In this paper, we investigate how investors who face both equity risk and credit risk would optimally allocate their financial wealth in a dynamic continuous-time setup. We model credit risk through the defaultable zero-coupon bond and solve the dynamics of its price after pricing it. Using stochastic control methods, we obtain a closed-form solution to this investment problem and characterize its variation with respect to different factors in the economy. We find that non-zero recovery rate of the credit-risky bond affects investors' decision in a fundamental way. Because of this, investors try to time the market conditions in their decision making process. It also induces hedging term in this setup of otherwise deterministic investment opportunity set. Through numerical examples, we show that the inclusion of credit market is shown to be able to enhance investors' welfare.

Suggested Citation

  • Yuanfeng Hou & Xiangrong Jin, 2002. "Optimal Investment With Default Risk," FAME Research Paper Series rp46b, International Center for Financial Asset Management and Engineering.
    • Handle: RePEc:fam:rpseri:rp46b
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    File URL: http://www.swissfinanceinstitute.ch/rp46b.pdf
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    References listed on IDEAS

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    Cited by:

    1. Lijun Bo & Xindan Li & Yongjin Wang & Xuewei Yang, 2013. "Optimal Investment and Consumption with Default Risk: HARA Utility," Asia-Pacific Financial Markets, Springer;Japanese Association of Financial Economics and Engineering, vol. 20(3), pages 261-281, September.
    2. Longjie Jia & Martijn Pistorius & Harry Zheng, 2017. "Dynamic Portfolio Optimization with Looping Contagion Risk," Papers 1710.05168, arXiv.org, revised Aug 2018.
    3. Giulia Di Nunno & Steffen Sjursen, 2013. "Information and optimal investment in defaultable assets," Papers 1312.6032, arXiv.org.
    4. Giulia Di Nunno & Steffen Sjursen, 2014. "Information And Optimal Investment In Defaultable Assets," International Journal of Theoretical and Applied Finance (IJTAF), World Scientific Publishing Co. Pte. Ltd., vol. 17(08), pages 1-27.
    5. Tomasz Bielecki & Inwon Jang, 2006. "Portfolio optimization with a defaultable security," Asia-Pacific Financial Markets, Springer;Japanese Association of Financial Economics and Engineering, vol. 13(2), pages 113-127, June.
    6. Kraft, Holger & Steffensen, Mogens, 2008. "How to invest optimally in corporate bonds: A reduced-form approach," Journal of Economic Dynamics and Control, Elsevier, vol. 32(2), pages 348-385, February.

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    More about this item

    Keywords

    Default Risk; Corporate Bond; Asset Allocation; Welfare Analysis;
    All these keywords.

    JEL classification:

    • D9 - Microeconomics - - Micro-Based Behavioral Economics
    • G11 - Financial Economics - - General Financial Markets - - - Portfolio Choice; Investment Decisions
    • D6 - Microeconomics - - Welfare Economics

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