Explicit Solutions to Optimal Risk-Averse Trading of Defaultable Bonds Under Heterogeneous Beliefs
27 Pages Posted: 23 Oct 2010 Last revised: 10 Dec 2015
Date Written: October 22, 2010
Abstract
This paper studies the problem of pricing and trading of defaultable bonds among investors with heterogeneous risk preferences and beliefs. Based on the utility indifference pricing methodology, we first construct the risk-averse bid-ask spread, which naturally widens as risk aversion or trading volume increases. In addition, we analyze the defaultable bond buyer's optimal static trading position under different market settings, including (i) when the market pricing rule is linear, and (ii) when the counterparty - single or multiple sellers - may have different risk preferences and beliefs. In each of these cases, we provide an explicit formula for the optimal trading position and examine the combined effects of risk aversions and beliefs. In particular, we find that belief heterogeneity, rather than the difference in risk aversion, is crucial to trigger a trade.
Keywords: Optimal Trading, Defaultable Bonds, Utility Indifference Pricing, Heterogeneous Beliefs, Structural Credit Risk
JEL Classification: G12, G13, C68
Suggested Citation: Suggested Citation