Implications of Correlated Default For Portfolio Allocation to Corporate Bonds
by Mark B. Wise of the California Institute of Technology, and
September 3, 2002
Abstract: This article deals with the problem of optimal allocation of capital to corporate bonds in fixed income portfolios when there is the possibility of correlated defaults. Using a multivariate normal Copula function for the joint default probabilities we show that retaining the first few moments of the portfolio default loss distribution gives an extremely good approximation to the full solution of the asset allocation problem. We provide detailed results on the convergence of the moment expansion and explore how the optimal portfolio allocation depends on recovery fractions, level of diversification and investment time horizon. Numerous numerical illustrations exhibit the results for simple portfolios and utility functions.
Published in: Journal of Investment Management, Vol. 3, No. 1, (First Quarter 2005), pp. 60-74.
This paper is republished as Ch.8 in...