Credit Portfolio Selection with Decaying Contagion Intensities
Mathematical Finance, Forthcoming
30 Pages Posted: 26 Sep 2015 Last revised: 19 Oct 2017
Date Written: October 18, 2017
We develop a fixed income portfolio framework capturing the exponential decay of contagious intensities between successive default events. We show that the value function of the control problem is the classical solution to a recursive system of second-order uniformly parabolic Hamilton-Jacobi-Bellman (HJB) partial differential equations (PDEs).
We analyze the interplay between risk premia, decay of default intensities, and their volatilities. Our comparative statics analysis finds that the investor chooses to go long only if he is capturing enough risk premia. If the default intensities deteriorate faster, the investor increases the size of his position if he goes short, or reduces the size of his position if he goes long.
Keywords: Fixed income investment, default decay, dynamic programming, parabolic PDEs
JEL Classification: G11, G31, C61, C11
Suggested Citation: Suggested Citation