Explicit Solutions to Optimal Risk-Averse Trading of Defaultable Bonds Under Heterogeneous Beliefs

27 Pages Posted: 23 Oct 2010 Last revised: 10 Dec 2015

See all articles by Tim Leung

Tim Leung

University of Washington - Department of Applied Math

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

Leung, Tim, Explicit Solutions to Optimal Risk-Averse Trading of Defaultable Bonds Under Heterogeneous Beliefs (October 22, 2010). Available at SSRN: https://ssrn.com/abstract=1694887 or http://dx.doi.org/10.2139/ssrn.1694887

Tim Leung (Contact Author)

University of Washington - Department of Applied Math ( email )

Lewis Hall 217
Department of Applied Math
Seattle, WA 98195
United States

HOME PAGE: http://faculty.washington.edu/timleung/

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