Portfolio Optimization in Defaultable Markets under Incomplete Information

by Giorgia Callegaro of the Laboratoire de Probabilités et Modèles Aléatoires & Université d'Évry Val d'Essonne,
Monique Jeanblanc of the Laboratoire de Probabilités et Modèles Aléatoires & Université d'Évry Val d'Essonne, and
Wolfgang Runggaldier of the University of Padova

August 9, 2010

Abstract: We consider the problem of maximization of expected utility from terminal wealth in a market model that is driven by a possibly not fully observable factor process and that takes explicitly into account the possibility of default for the individual assets as well as contagion (direct and information induced) among them. It is a multinomial model in discrete time that allows for an explicit solution. We discuss the solution within our defaultable and partial information setup, in particular we study its robustness. Numerical results are derived in the case of a log-utility function and they can be analogously obtained for a power utility function.

JEL Classification: G11, C61, C11.

Keywords: Portfolio optimization, partial information, credit risk, dynamic programming, robust solutions

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