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How to Invest Optimally in Corporate Bonds: A Reduced-Form Approach


  • Holger Kraft

    (Department of Mathematics, University of Kaiserslautern)

  • Mogens Steffensen

    (Fraunhofer ITWM, Institute for Industrial Mathematics, Department of Finance, Kaiserslautern)


In this paper, we analyze the impact of default risk on the portfolio decision of an investor wishing to invest in corporate bonds. Default risk is modeled via a reduced form approach and we allow for random recovery as well as joint default events. Depending on the structure of the model, we are able to derive almost explicit results for the optimal portfolio strategies. It is demonstrated how these strategies change if common default factors can trigger defaults of more than one bond or different recovery assumptions are imposed. In particular, we analyze the effect of beta distributed loss rates.

Suggested Citation

  • Holger Kraft & Mogens Steffensen, 2005. "How to Invest Optimally in Corporate Bonds: A Reduced-Form Approach," FRU Working Papers 2005/07, University of Copenhagen. Department of Economics. Finance Research Unit.
  • Handle: RePEc:kud:kuiefr:200507

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    Cited by:

    1. Morten Mosegaard Christensen & Eckhard Platen, 2007. "Sharpe Ratio Maximization And Expected Utility When Asset Prices Have Jumps," International Journal of Theoretical and Applied Finance (IJTAF), World Scientific Publishing Co. Pte. Ltd., vol. 10(08), pages 1339-1364.

    More about this item


    portfolio optimization; stochastic interest rates; default risk; recovery risk; beta distribution;

    JEL classification:

    • G11 - Financial Economics - - General Financial Markets - - - Portfolio Choice; Investment Decisions
    • G33 - Financial Economics - - Corporate Finance and Governance - - - Bankruptcy; Liquidation

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