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The Effects of Credit Risk on Dynamic Portfolio Management: A New Computational Approach

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  • Kwamie Dunbar

    (University of Connecticut and Sacred Heart University)

Abstract

The study investigates the role of credit risk in a continuous time stochastic asset allocation model, since the traditional dynamic framework does not provide credit risk flexibility. The general model of the study extends the traditional dynamic efficiency framework by explicitly deriving the optimal value function for the infinite horizon stochastic control problem via a weighted volatility measure of market and credit risk. The model's optimal strategy was then compared to that obtained from a benchmark Markowitz-type dynamic optimization framework to determine which specification adequately reflects the optimal terminal investment returns and strategy under credit and market risks. The paper shows that an investor's optimal terminal return is lower than typically indicated under the traditional mean-variance framework during periods of elevated credit risk. Hence I conclude that, while the traditional dynamic mean-variance approach may indicate the ideal, in the presence of credit-risk it does not accurately reflect the observed optimal returns, terminal wealth and portfolio selection strategies.

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Bibliographic Info

Paper provided by University of Connecticut, Department of Economics in its series Working papers with number 2009-03.

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Length: 35 pages
Date of creation: Jan 2009
Date of revision: Feb 2009
Handle: RePEc:uct:uconnp:2009-03

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Postal: University of Connecticut 341 Mansfield Road, Unit 1063 Storrs, CT 06269-1063
Phone: (860) 486-4889
Fax: (860) 486-4463
Web page: http://www.econ.uconn.edu/
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Related research

Keywords: Dynamic Strategies; Credit Risk; Mean-Variance Analysis; Optimal Portfolio Selection; Viscosity Solution; Credit Default Swaps; Default Risk; Dynamic Control;

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References

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  1. Hakansson, Nils H, 1970. "Optimal Investment and Consumption Strategies Under Risk for a Class of Utility Functions," Econometrica, Econometric Society, Econometric Society, vol. 38(5), pages 587-607, September.
  2. Samuelson, Paul A, 1969. "Lifetime Portfolio Selection by Dynamic Stochastic Programming," The Review of Economics and Statistics, MIT Press, vol. 51(3), pages 239-46, August.
  3. Kwamie Dunbar, 2007. "US Corporate Default Swap Valuation: The Market Liquidity Hypothesis and Autonomous Credit Risk," Working papers, University of Connecticut, Department of Economics 2007-08, University of Connecticut, Department of Economics.
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Cited by:
  1. Kwamie Dunbar, 2009. "Solving the Non-Linear Dynamic Asset Allocation Problem: Effects of Arbitrary Stochastic Processes and Unsystematic Risk on the Super Efficient Portfolio Space," Working papers, University of Connecticut, Department of Economics 2009-04, University of Connecticut, Department of Economics.

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