Reaching Nirvana with a Defaultable Asset?

Abstract:     
We contribute a new insight into the pre-crisis massive levered exposures to default risk by formulating a parsimonious, closed-form analysis of conspicuous risk taking in default-prone assets. Under no arbitrage, default risk is compensated by an ‘yield pickup’ that can strongly attract aggressive investors via an investment horizon effect in their optimal non-myopic portfolios. We show that default risk decoupled from event risk does not discourage the formation of markedly geared portfolios. Our results add a new portfolio-based perspective to a mainstream model of default risk: even if arbitrage-free, the model may not find unconstrained support in general equilibrium.

Number of Pages in PDF File: 36

Keywords: dynamic asset allocation, defaultable asset, Sharpe-ratio uncertainty, levered non-myopic speculation, the Constant Elasticity of Variance (CEV) model

JEL Classification: G11, G12, C61

working papers series