Optimal Investment in Credit Derivatives Portfolio Under Contagion Risk

Download or read book Optimal Investment in Credit Derivatives Portfolio Under Contagion Risk written by Lijun Bo and published by . This book was released on 2014 with total page 39 pages. Available in PDF, EPUB and Kindle. Book excerpt: We consider the optimal portfolio problem of a power investor who wishes to allocate her wealth between several credit default swaps (CDSs) and a money market account. We model contagion risk among the reference entities in the portfolio using a reduced form Markovian model with interacting default intensities. Using the dynamic programming principle, we establish a lattice dependence structure between the Hamiltonian-Jacobi-Bellman equations associated with the default states of the portfolio. We show existence and uniqueness of a classical solution to each equation and characterize them in terms of solutions to inhomogeneous Bernoulli's type ODEs. We provide a precise characterization for the directionality of the CDS investment strategy and perform a numerical analysis to assess the impact of default contagion. We find that the increased intensity triggered by default of a very risky entity strongly impacts size and directionality of the investor strategy. Such findings outline the key role played by default contagion when investing in portfolios subject to multiple sources of default risk.