How to Invest Optimally in Corporate Bonds: A reduced-form approach

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How to Invest Optimally in Corporate Bonds: A reduced-form approach

by Holger Kraft of the University of Kaiserslautern, and
Mogens Steffensen of the University of Copenhagen

May 10, 2005

Abstract: In this paper, we analyze the impact of default risk on the portfolio decision of an investor wishing to invest in corporate bonds. Default risk is modeled via a reduced form approach and we allow for random recovery as well as joint default events. Depending on the structure of the model, we are able to derive almost explicit results for the optimal portfolio strategies. It is demonstrated how these strategies change if common default factors can trigger defaults of more than one bond or different recovery assumptions are imposed. In particular, we analyze the effect of beta distributed loss rates.

JEL Classification: G11, G33.

AMS Classification: 93E20.

Keywords: portfolio optimization, stochastic interest rates, default risk, recovery risk.

Forthcoming in: Journal of Economic Dynamics and Control.

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