Portfolio optimization under credit risk

Based on the models of Hull & White (1990) for the pricing of non-defaultable bonds and Schmid & Zagst (2000) for the pricing of defaultable bonds we develop a framework for the optimal allocation of assets out of a universe of sovereign bonds with different time to maturity and quality of the issuer. We estimate the model parameters by applying Kalman filtering methods as described in (Schmid & Kalemanova 2002). Based on these estimates we simulate the prices for a given set of bonds for a future time horizon. For each future time step and for each given portfolio composition these scenarios yield distributions of future cash flows and portfolio values. We show how the portfolio composition can be optimized by maximizing the expected final value or return of the portfolio under given constraints.