The Effects of Credit Risk on Dynamic Portfolio Management: A New Computational Approach

Kwamie O. Dunbar ()

No 2009-03, Working papers from University of Connecticut, Department of Economics

Abstract: The study investigates the role of credit risk in a continuous time stochastic asset allocation model, since the traditional dynamic framework does not provide credit risk flexibility. The general model of the study extends the traditional dynamic efficiency framework by explicitly deriving the optimal value function for the infinite horizon stochastic control problem via a weighted volatility measure of market and credit risk. The model's optimal strategy was then compared to that obtained from a benchmark Markowitz-type dynamic optimization framework to determine which specification adequately reflects the optimal terminal investment returns and strategy under credit and market risks. The paper shows that an investor's optimal terminal return is lower than typically indicated under the traditional mean-variance framework during periods of elevated credit risk. Hence I conclude that, while the traditional dynamic mean-variance approach may indicate the ideal, in the presence of credit-risk it does not accurately reflect the observed optimal returns, terminal wealth and portfolio selection strategies.

Keywords: Dynamic Strategies; Credit Risk; Mean-Variance Analysis; Optimal Portfolio Selection; Viscosity Solution; Credit Default Swaps; Default Risk; Dynamic Control (search for similar items in EconPapers)
JEL-codes: G0 G10 C02 C15 (search for similar items in EconPapers)
New Economics Papers: this item is included in nep-cfn, nep-cmp and nep-rmg
Date: 2009-01, Revised 2009-02
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Persistent link: http://EconPapers.repec.org/RePEc:uct:uconnp:2009-03

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