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), a stock index, 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 Hamiltonian-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’s type ODEs. We perform a numerical analysis to assess the impact of default contagion and 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. AMS 2000 subject classifications: 3E20, 60J20.