The Effects of Credit Risk on Dynamic Portfolio Management: A New Computational Approach

The study investigates the role of credit risk in a continuous time stochastic asset allocation model, since the traditional dynamic framework does not provide credit risk flexibility. The general model of the study extends the traditional dynamic efficiency framework by explicitly deriving the optimal value function for the infinite horizon stochastic control problem via a weighted volatility measure of market and credit risk. The model's optimal strategy was then compared to that obtained from a benchmark Markowitz-type dynamic optimization framework to determine which specification adequately reflects the optimal terminal investment returns and strategy under credit and market risks. The paper shows that an investor's optimal terminal return is lower than typically indicated under the traditional mean-variance framework during periods of elevated credit risk. Hence I conclude that, while the traditional dynamic mean-variance approach may indicate the ideal, in the presence of credit-risk it does not accurately reflect the observed optimal returns, terminal wealth and portfolio selection strategies.

Volume 11, Number 2: April/May 2005

Page 2 – The Vice Provost cites 2004/2005 as a year of significant accomplishments for the Libraries. • The Dodd Research Center and the Human Rights Institute plan a conference on economic human rights for October. Page 3 - Researcher Bill V. Mullen talks about the work of avant garde musician, composer, and author Fred Ho, whose archive is in Archives & Special Collections. Page 4 - Students tell us why they come to the library. • The Dodd Research Center commissions two students to create a logo for its 10th anniversary celebration. • Fragile pamphlets are given new life in the Conservation Lab. Page 5 - The library sponsors a national symposium to explore new technology. • Our newest digital project can lead you to everything you ever wanted to know about Connecticut. • A new Pharmacy Library will open its doors in June. Page 6 - Staff News: service anniversaries and new faces. Page 7 - The Class of 1955 is raising $50,000 for an undergraduate instruction classroom in the library.