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Optimal Portfolios with Credit Default Swaps

Author

Listed:
  • Giuseppe Ambrosini

    (University of Milan)

  • Francesco Menoncin

    (University of Brescia)

Abstract

Using a continuous-time, stochastic, and dynamic framework, this study derives a closed-form solution for the optimal investment problem for an agent with hyperbolic absolute risk aversion preferences for maximising the expected utility of his or her final wealth. The agent invests in a frictionless, complete market in which a riskless asset, a (defaultable) bond, and a credit default swap written on the bond are listed. The model is calibrated to market data of six European countries and assesses the behaviour of an investor exposed to different levels of sovereign risk. A numerical analysis shows that it is optimal to issue credit default swaps in a larger quantity than that of bonds, which are optimally purchased. This speculative strategy is more aggressive in countries characterised by higher sovereign risk. This result is confirmed when the investor is endowed with a different level of risk aversion. Finally, we solve a static version of the optimisation problem and show that the speculative/hedging strategy is definitely different with respect to the dynamic one.

Suggested Citation

  • Giuseppe Ambrosini & Francesco Menoncin, 2018. "Optimal Portfolios with Credit Default Swaps," Journal of Financial Services Research, Springer;Western Finance Association, vol. 54(1), pages 81-109, August.
    • Handle: RePEc:kap:jfsres:v:54:y:2018:i:1:d:10.1007_s10693-016-0264-z
    DOI: 10.1007/s10693-016-0264-z
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    References listed on IDEAS

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    More about this item

    Keywords

    Credit default swap; Optimal dynamic programming; Hyperbolic absolute risk aversion;
    All these keywords.

    JEL classification:

    • G11 - Financial Economics - - General Financial Markets - - - Portfolio Choice; Investment Decisions
    • G20 - Financial Economics - - Financial Institutions and Services - - - General
    • G12 - Financial Economics - - General Financial Markets - - - Asset Pricing; Trading Volume; Bond Interest Rates

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