N. Mirjolet, G. Dondi, F. Herzog, S. Keel, and H.P. Geering (Switzerland)
Corporate Bond Pricing, Credit Portfolio Optimization, Hull-White Term Structure Model
In this paper, we provide an optimization and simulation framework allowing corporate bond portfolio managers to follow or outperform a given benchmark index with the help of only a small set of bonds. The underlying bond pricing model integrates the main sources of risks, such as market or credit risk. Correlated stochastic interest rates and credit spreads, independent rating migrations, based on empirical transition matrices, are incorporated in a unified intensity-based pricing framework. However, contrary to the traditionnal approach, we avoid the use of Monte-Carlo simulations by deriving the explicit price distribution of a corporate coupon bond. Based upon the bond pricing model, we formulate and solve a one period tracking error problem as a linear pro gram. Multiple optimization constraints allow to accurately manage and control the credit risk. Empirical results obtained by dynamically replicating the JPMorgan Aggregated Euro Credit Index over a five year recent period substantiate the conclusions of this paper.
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