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Optimal Investment under Information Driven Contagious Distress

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  • Lijun Bo
  • Agostino Capponi

Abstract

We introduce a dynamic optimization framework to analyze optimal portfolio allocations within an information driven contagious distress model. The investor allocates his wealth across several stocks whose growth rates and distress intensities are driven by a hidden Markov chain, and also influenced by the distress state of the economy. We show that the optimal investment strategies depend on the gradient of value functions, recursively linked to each other via the distress states. We establish uniform bounds for the solutions to a sequence of approximation problems, show their convergence to the unique Sobolev solution of the recursive system of Hamilton-Jacobi-Bellman partial differential equations (HJB PDEs), and prove a verification theorem. We provide a numerical study to illustrate the sensitivity of the strategies to contagious distress, stock volatilities and risk aversion.

Suggested Citation

  • Lijun Bo & Agostino Capponi, 2016. "Optimal Investment under Information Driven Contagious Distress," Papers 1612.06133, arXiv.org.
    • Handle: RePEc:arx:papers:1612.06133
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    References listed on IDEAS

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    1. Agostino Capponi & José Figueroa-López & Andrea Pascucci, 2015. "Dynamic credit investment in partially observed markets," Finance and Stochastics, Springer, vol. 19(4), pages 891-939, October.
    2. Lijun Bo & Agostino Capponi, 2016. "Optimal Investment In Credit Derivatives Portfolio Under Contagion Risk," Mathematical Finance, Wiley Blackwell, vol. 26(4), pages 785-834, October.
    3. Tomas Björk & Mark Davis & Camilla Landén, 2010. "Optimal investment under partial information," Mathematical Methods of Operations Research, Springer;Gesellschaft für Operations Research (GOR);Nederlands Genootschap voor Besliskunde (NGB), vol. 71(2), pages 371-399, April.
    4. Torben G. Andersen & Tim Bollerslev & Francis X. Diebold & Paul Labys, 2003. "Modeling and Forecasting Realized Volatility," Econometrica, Econometric Society, vol. 71(2), pages 579-625, March.
    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.
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