Portfolio allocation to corporate bonds with correlated defaults

This article deals with the problem of optimal allocation of capital to corporate bonds in fixed income portfolios when there is the possibility ofcorrelated defaults. Under fairly general assumptions for the distribution of thetotal net assets of a set of firms we show that retaining the first few momentsof the portfolio default loss distribution gives an extremely good approximationto the full solution of the asset allocation problem. We provide detailedresults on the convergence of the moment expansion. We also provide explicitresults for the inverse problem, ie, for a given allocation to the set of riskybonds, what is the average risk premium required to make the portfoliooptimal. Numerous numerical illustrations exhibit the results for realistic portfoliosand utility functions.

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Online References:
Das, S., Fong, G. and Geng, G. (2001). The impact of correlated default risk on credit portfolios. Journal of Fixed Income 11(3), 9–19.

Rebonato, R. and Jäckel, P. (2000). The most general methodology for creating a valid correlation matrix for risk management and option pricing purposes. The Journal of Risk 2(2), 17–26.

Zhou, C. (2001). An analysis of default correlations and multiple defaults. The Review ofFinancial Studies 12(2), 555–76.