Optimal Investment with Default Risk

FAME Research Paper No. 46

42 Pages Posted: 19 Apr 2003

See all articles by Xiangrong Jin

Xiangrong Jin

École Polytechnique Fédérale de Lausanne

Yuanfeng Hou

The University of Hong Kong - School of Economics and Finance

Date Written: December 2002

Abstract

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.

Keywords: Default Risk, Corporate Bond, Asset Allocation, Welfare Analysis

JEL Classification: D9, G11, D6

Suggested Citation

Jin, Xiangrong and Hou, Yuanfeng, Optimal Investment with Default Risk (December 2002). FAME Research Paper No. 46, Available at SSRN: https://ssrn.com/abstract=372020 or http://dx.doi.org/10.2139/ssrn.372020

Xiangrong Jin (Contact Author)

École Polytechnique Fédérale de Lausanne ( email )

40, Boulevard du Pont-d'Arve
40, Bd du Pont-d'Arve
1211 Geneva 4, CH-6900
Switzerland

Yuanfeng Hou

The University of Hong Kong - School of Economics and Finance ( email )

8th Floor Kennedy Town Centre
23 Belcher's Street
Kennedy Town
Hong Kong