Dynamic Portfolio Optimization with a Defaultable Security and Regime Switching

TL;DR

This paper develops a dynamic portfolio optimization model in a regime-switching market with defaultable securities, deriving explicit strategies and value functions for logarithmic utility investors, and analyzing the impact of market regimes and default risks.

Contribution

It introduces a novel framework combining regime-switching dynamics with defaultable securities and provides explicit solutions for optimal investment strategies.

Findings

Explicit optimal strategies for logarithmic utility investors.

Default intensities significantly influence optimal asset allocation.

Market regimes affect the value functions and investment decisions.

Abstract

We consider a portfolio optimization problem in a defaultable market with finitely-many economical regimes, where the investor can dynamically allocate her wealth among a defaultable bond, a stock, and a money market account. The market coefficients are assumed to depend on the market regime in place, which is modeled by a finite state continuous time Markov process. We rigorously deduce the dynamics of the defaultable bond price process in terms of a Markov modulated stochastic differential equation. Then, by separating the utility maximization problem into the pre-default and post-default scenarios, we deduce two coupled Hamilton-Jacobi-Bellman equations for the post and pre-default optimal value functions and show a novel verification theorem for their solutions. We obtain explicit optimal investment strategies and value functions for an investor with logarithmic utility. We finish with an economic analysis in the case of a market with two regimes and homogenous transition rates, and show the impact of the default intensities and loss rates on the optimal strategies and value functions.