Optimal Investment With Default Risk

Yuanfeng Hou and Xiangrong Jin
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Yuanfeng Hou: Yale University
Xiangrong Jin: FAME and University of Lausanne

FAME Research Paper Series from International Center for Financial Asset Management and Engineering

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 (search for similar items in EconPapers)
JEL-codes: D6 D9 G11 (search for similar items in EconPapers)
Date: 2002-03
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Citations: View citations in EconPapers (6)

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