Implications of Correlated Default for Portfolio Allocation to Corporate Bonds

California Inst. of Tech. Working Paper No. CALT-68-2405

18 Pages Posted: 9 Sep 2002

See all articles by Mark B. Wise

Mark B. Wise

California Institute of Technology

Vineer Bhansali

LongTail Alpha, LLC

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Abstract

This article deals with the problem of optimal allocation of capital to corporate bonds in fixed income portfolios when there is the possibility of correlated defaults. Using a multivariate normal Copula function for the joint default probabilities we show that retaining the first few moments of the portfolio default loss distribution gives an extremely good approximation to the full solution of the asset allocation problem. We provide detailed results on the convergence of the moment expansion and explore how the optimal portfolio allocation depends on recovery fractions, level of diversification and investment time horizon. Numerous numerical illustrations exhibit the results for simple portfolios and utility functions.

JEL Classification: G00, G10, G11

Suggested Citation

Wise, Mark B. and Bhansali, Vineer, Implications of Correlated Default for Portfolio Allocation to Corporate Bonds. California Inst. of Tech. Working Paper No. CALT-68-2405. Available at SSRN: https://ssrn.com/abstract=327840 or http://dx.doi.org/10.2139/ssrn.327840

Mark B. Wise (Contact Author)

California Institute of Technology ( email )

Pasadena, CA 91125
United States
626-395-6687 (Phone)
626-568-8473 (Fax)

Vineer Bhansali

LongTail Alpha, LLC ( email )

500 Newport Center Drive
Suite 820
Newport Beach, CA 92660
United States

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