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Journal of Financial Services Research
Published in: Journal of Financial Services Research 1/2018

03-09-2016

Optimal Portfolios with Credit Default Swaps

Authors: Giuseppe Ambrosini, Francesco Menoncin

Published in: Journal of Financial Services Research | Issue 1/2018

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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.
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Appendix
Available only for authorised users
Footnotes
1
Bank for International Settlements, OTC derivatives market activity in the first half of 2008, available at: http://​www.​bis.​org/​publ/​otc_​hy0811.​pdf.
 
2
Regulation (EU) No 236/2012 of the European Parliament and of the Council of 14 March 2012 on short selling and certain aspects of CDSs.
 
3
The case with dependent Wiener processes can be easily obtained through Cholesky’s decomposition.
 
4
We assume that the stochastic processes driven by these Wiener processes satisfy all the usual properties needed for the existence of a unique and strong solution (Karatzas and Shreve 1998; Øksendal 2000; Björk 2009).
 
5
In order to calculate the average constant coupon, we seek 5-year fixed-rate bonds issued by the six countries from November 2002 to December 2014.
 
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Metadata
Title
Optimal Portfolios with Credit Default Swaps
Authors
Giuseppe Ambrosini
Francesco Menoncin
Publication date
03-09-2016
Publisher
Springer US
Published in
Journal of Financial Services Research / Issue 1/2018
Print ISSN: 0920-8550
Electronic ISSN: 1573-0735
DOI
https://doi.org/10.1007/s10693-016-0264-z