An ABC of Portfolio Choice: Asset Allocation With Bankruptcy and Contagion

Abstract

In this paper, we consider the asset allocation problem of an investor allocating his funds between several corporate bonds and a money market account.

In particular, we provide a realistic model of financial distress: Firstly, we model Chapter 7 and Chapter 11 bankruptcies as different possible outcomes of financial distress.

Secondly, we take into consideration that, in practice, default is not the end, but the beginning of financial distress, eventually leading to a reorganization or a liquidation of a distressed firm.

Thirdly and most importantly, we are able to analyze the impact of contagion on an investor's demand for corporate bonds. Contagion is an important phenomenon, as it reduces the investor's ability to diversify his portfolio. Although widely recognized in the literature about the pricing of defaultable securities, to our knowledge, little work has been done quantifying the impact of contagion on security demands in a continuous-time framework.

Keywords: portfolio optimization, liquidation, reorganization, default, finite state Markov chain

JEL Classification: G11, G33