Portfolio Optimization under Credit Risk
by R. Zagst, j. Kehrbaum and B. Schmid

Basied on the models of Hull and Whilet (1990) fpr tje [rocomg pf mpm-defaultable bonds and Schmid and Zagst (2000) for the pricing of defaultable bonds, we develop a framework for the optimal allocation of assets out a universe of soverign bonds with different times to maturity and quality of the issurer. Our methodology may be applied to other asset classes such as corporate bonds.

We estimate the model parameters by applying Kalman filtering methods as described in Schmid and Kalemanova (2002).Based on these estimates, we apply Monte Carlo simulation techniques to simulate prices for a given set of bonds for a future time-horizon.For each future time-step and each given portfolio composition, these scenarios yield distributins of futre cash flows and portfolio values.

We show the optimization of portfolio composition by maximizing the return of the portfolio under given constraints (e.g. a minimum cash flow per period to cover the liabilities of a company and a maximum tolerated risk).To visualize our methodology, we present a case staudy of a portfolio consisting of German, Italian and Greek sovereign bonds.