Optimal Credit Swap Portfolios

Kay Giesecke (), Baeho Kim (), Jack Kim () and Gerry Tsoukalas ()
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Kay Giesecke: Department of Management Science and Engineering, Stanford University, Stanford, California 94305
Baeho Kim: Korea University Business School, Seoul 136-701, Korea
Jack Kim: J.P. Morgan, New York, New York 10017
Gerry Tsoukalas: The Wharton School, University of Pennsylvania, Philadelphia, Pennsylvania 19104

Management Science, 2014, vol. 60, issue 9, 2291-2307

Abstract: This paper formulates and solves the selection problem for a portfolio of credit swaps. The problem is cast as a goal program that entails a constrained optimization of preference-weighted moments of the portfolio value at the investment horizon. The portfolio value takes account of the exact timing of protection premium and default loss payments, as well as any mark-to-market profits and losses realized at the horizon. The constraints address collateral and solvency requirements, initial capital, position limits, and other trading constraints that credit swap investors often face in practice. The multimoment formulation accommodates the complex distribution of the portfolio value, which is a nested expectation under risk-neutral and actual probabilities. It also generates computational tractability. Numerical results illustrate the features of optimal portfolios. In particular, we find that credit swap investment constraints can have a significant impact on optimal portfolios, even for simple investment objectives. Our problem formulation and solution approach extend to corporate bond portfolios and mixed portfolios of corporate bonds and credit derivatives. This paper was accepted by Wei Xiong, finance .

Keywords: finance; investments; portfolio optimization; credit swaps (search for similar items in EconPapers)
Date: 2014
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Citations: View citations in EconPapers (8)

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