Credit Portfolio Selection with Decaying Contagion Intensities

Mathematical Finance, Forthcoming

30 Pages Posted: 26 Sep 2015 Last revised: 19 Oct 2017

See all articles by Lijun Bo

Lijun Bo

University of Science and Technology of China (USTC)

Agostino Capponi

Columbia University - Department of Industrial Engineering and Operations Research

Peng-Chu Chen

The University of Hong Kong

Date Written: October 18, 2017

Abstract

We develop a fixed income portfolio framework capturing the exponential decay of contagious intensities between successive default events. We show that the value function of the control problem is the classical solution to a recursive system of second-order uniformly parabolic Hamilton-Jacobi-Bellman (HJB) partial differential equations (PDEs).

We analyze the interplay between risk premia, decay of default intensities, and their volatilities. Our comparative statics analysis finds that the investor chooses to go long only if he is capturing enough risk premia. If the default intensities deteriorate faster, the investor increases the size of his position if he goes short, or reduces the size of his position if he goes long.

Keywords: Fixed income investment, default decay, dynamic programming, parabolic PDEs

JEL Classification: G11, G31, C61, C11

Suggested Citation

Bo, Lijun and Capponi, Agostino and Chen, Peng-Chu, Credit Portfolio Selection with Decaying Contagion Intensities (October 18, 2017). Mathematical Finance, Forthcoming, Available at SSRN: https://ssrn.com/abstract=2665444 or http://dx.doi.org/10.2139/ssrn.2665444

Lijun Bo

University of Science and Technology of China (USTC) ( email )

96, Jinzhai Road
Hefei, Anhui 230026
China

Agostino Capponi (Contact Author)

Columbia University - Department of Industrial Engineering and Operations Research ( email )

Peng-Chu Chen

The University of Hong Kong ( email )

Pokfulam Road
Hong Kong, Pokfulam HK
China

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