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

37 Pages Posted: 30 Jul 2006

See all articles by Mogens Steffensen

Mogens Steffensen

University of Copenhagen

Holger Kraft

Goethe University Frankfurt

Date Written: February 27, 2007


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

Suggested Citation

Steffensen, Mogens and Kraft, Holger, An ABC of Portfolio Choice: Asset Allocation With Bankruptcy and Contagion (February 27, 2007). EFA 2007 Ljubljana Meetings Paper, Available at SSRN: or

Mogens Steffensen

University of Copenhagen ( email )

Universitetsparken 5
DK-2100 Copenhagen

Holger Kraft (Contact Author)

Goethe University Frankfurt ( email )

Faculty of Economics and Business
Theodor-W.-Adorno-Platz 3
Frankfurt am Main, 60323

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