OPTIMAL INVESTMENT IN CREDIT DERIVATIVES PORTFOLIO UNDER CONTAGION RISK

We consider the optimal portfolio problem of a power investor who wishes to allocate her wealth between several credit default swaps (CDSs) and a money market account. We model contagion risk among the reference entities in the portfolio using a reduced‐form Markovian model with interacting default intensities. Using the dynamic programming principle, we establish a lattice dependence structure between the Hamilton‐Jacobi‐Bellman equations associated with the default states of the portfolio. We show existence and uniqueness of a classical solution to each equation and characterize them in terms of solutions to inhomogeneous Bernoulli type ordinary differential equations. We provide a precise characterization for the directionality of the CDS investment strategy and perform a numerical analysis to assess the impact of default contagion. We find that the increased intensity triggered by default of a very risky entity strongly impacts size and directionality of the investor strategy. Such findings outline the key role played by default contagion when investing in portfolios subject to multiple sources of default risk.