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Optimal Investment With Default Risk

  • Yuanfeng Hou

    (Yale University)

  • Xiangrong Jin

    (FAME and University of Lausanne)

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    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.

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    Paper provided by International Center for Financial Asset Management and Engineering in its series FAME Research Paper Series with number rp46b.

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    Date of creation: Mar 2002
    Date of revision:
    Handle: RePEc:fam:rpseri:rp46b
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    1. R. C. Merton, 1970. "Optimum Consumption and Portfolio Rules in a Continuous-time Model," Working papers 58, Massachusetts Institute of Technology (MIT), Department of Economics.
    2. Kwan, Simon H., 1996. "Firm-specific information and the correlation between individual stocks and bonds," Journal of Financial Economics, Elsevier, vol. 40(1), pages 63-80, January.
    3. Gregory R. Duffee, 1996. "Estimating the price of default risk," Finance and Economics Discussion Series 96-29, Board of Governors of the Federal Reserve System (U.S.).
    4. Philip H. Dybvig & Chi-fu Huang, 1988. "Nonnegative Wealth, Absence of Arbitrage, and Feasible Consumption Plans," Cowles Foundation Discussion Papers 860, Cowles Foundation for Research in Economics, Yale University.
    5. John Y. Campbell & Luis M. Viceira, 2000. "Who Should Buy Long-Term Bonds?," Harvard Institute of Economic Research Working Papers 1895, Harvard - Institute of Economic Research.
    6. Ammer, John & Campbell, John, 1993. "What Moves the Stock and Bond Markets? A Variance Decomposition for Long-Term Asset Returns," Scholarly Articles 3382857, Harvard University Department of Economics.
    7. Longstaff, Francis A & Schwartz, Eduardo S, 1995. " A Simple Approach to Valuing Risky Fixed and Floating Rate Debt," Journal of Finance, American Finance Association, vol. 50(3), pages 789-819, July.
    8. Hayne E. Leland and Klaus Bjerre Toft., 1995. "Optimal Capital Structure, Endogenous Bankruptcy, and the Term Structure of Credit Spreads," Research Program in Finance Working Papers RPF-259, University of California at Berkeley.
    9. Jarrow, Robert A & Turnbull, Stuart M, 1995. " Pricing Derivatives on Financial Securities Subject to Credit Risk," Journal of Finance, American Finance Association, vol. 50(1), pages 53-85, March.
    10. Pierre Collin-Dufresne, 2001. "Do Credit Spreads Reflect Stationary Leverage Ratios?," Journal of Finance, American Finance Association, vol. 56(5), pages 1929-1957, October.
    11. Harrison, J. Michael & Kreps, David M., 1979. "Martingales and arbitrage in multiperiod securities markets," Journal of Economic Theory, Elsevier, vol. 20(3), pages 381-408, June.
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