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Implications of Correlated Default For Portfolio Allocation To Corporate Bonds

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  • Mark B. Wise
  • Vineer Bhansali

Abstract

This article deals with the problem of optimal allocation of capital to corporate bonds in fixed income portfolios when there is the possibility of correlated defaults. Using a multivariate normal Copula function for the joint default probabilities we show that retaining the first few moments of the portfolio default loss distribution gives an extremely good approximation to the full solution of the asset allocation problem. We provide detailed results on the convergence of the moment expansion and explore how the optimal portfolio allocation depends on recovery fractions, level of diversification and investment time horizon. Numerous numerical illustrations exhibit the results for simple portfolios and utility functions.

Suggested Citation

  • Mark B. Wise & Vineer Bhansali, 2002. "Implications of Correlated Default For Portfolio Allocation To Corporate Bonds," Papers nlin/0209010, arXiv.org.
  • Handle: RePEc:arx:papers:nlin/0209010
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    File URL: http://arxiv.org/pdf/nlin/0209010
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    References listed on IDEAS

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    1. Mark B. Wise & Vineer Bhansali, 2002. "Portfolio Allocation to Corporate Bonds with Correlated Defaults," Papers nlin/0205011, arXiv.org, revised Jun 2002.
    2. Leland, Hayne E & Toft, Klaus Bjerre, 1996. " Optimal Capital Structure, Endogenous Bankruptcy, and the Term Structure of Credit Spreads," Journal of Finance, American Finance Association, vol. 51(3), pages 987-1019, July.
    3. Merton, Robert C, 1974. "On the Pricing of Corporate Debt: The Risk Structure of Interest Rates," Journal of Finance, American Finance Association, vol. 29(2), pages 449-470, May.
    4. Black, Fischer & Cox, John C, 1976. "Valuing Corporate Securities: Some Effects of Bond Indenture Provisions," Journal of Finance, American Finance Association, vol. 31(2), pages 351-367, May.
    5. Zhou, Chunsheng, 2001. "An Analysis of Default Correlations and Multiple Defaults," Review of Financial Studies, Society for Financial Studies, vol. 14(2), pages 555-576.
    6. Altman, Edward I, 1989. " Measuring Corporate Bond Mortality and Performance," Journal of Finance, American Finance Association, vol. 44(4), pages 909-922, September.
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    Cited by:

    1. Panchenko, Valentyn, 2005. "Goodness-of-fit test for copulas," Physica A: Statistical Mechanics and its Applications, Elsevier, vol. 355(1), pages 176-182.
    2. Justin A. Sirignano & Gerry Tsoukalas & Kay Giesecke, 2016. "Large-Scale Loan Portfolio Selection," Operations Research, INFORMS, vol. 64(6), pages 1239-1255, December.

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