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Title: Dynamic Investment and Counterparty Risk

Abstract

We introduce a dynamic optimization framework in which collateral is used to mitigate losses arising at counterparty’s default. The investor faces two sources of risk: the default risk of the entity referencing the traded credit swap security, and counterparty risk generated from the default event of the trading counterparty. We show that the value function of the control problem coincides with the classical solution of a nonlinear dynamic programming equation. We provide an explicit characterization of the optimal investment strategy, and show that the investor does not trade if counterparty risk is sufficiently high. These findings suggest that moving credit swap trades into well-designed clearinghouses may stimulate economic activities.

Authors:
 [1];  [2]
  1. University of Science and Technology of China, School of Mathematical Sciences (China)
  2. Columbia University, Department of Industrial Engineering and Operations Research (United States)
Publication Date:
OSTI Identifier:
22756224
Resource Type:
Journal Article
Journal Name:
Applied Mathematics and Optimization
Additional Journal Information:
Journal Volume: 77; Journal Issue: 1; Other Information: Copyright (c) 2018 Springer Science+Business Media, LLC, part of Springer Nature; Article Copyright (c) 2016 Springer Science+Business Media New York; http://www.springer-ny.com; Country of input: International Atomic Energy Agency (IAEA); Journal ID: ISSN 0095-4616
Country of Publication:
United States
Language:
English
Subject:
71 CLASSICAL AND QUANTUM MECHANICS, GENERAL PHYSICS; DYNAMIC PROGRAMMING; HAZARDS; INVESTMENT; MATHEMATICAL SOLUTIONS; NONLINEAR PROBLEMS; TRADE

Citation Formats

Bo, Lijun, and Capponi, Agostino. Dynamic Investment and Counterparty Risk. United States: N. p., 2018. Web. doi:10.1007/S00245-016-9364-2.
Bo, Lijun, & Capponi, Agostino. Dynamic Investment and Counterparty Risk. United States. doi:10.1007/S00245-016-9364-2.
Bo, Lijun, and Capponi, Agostino. Thu . "Dynamic Investment and Counterparty Risk". United States. doi:10.1007/S00245-016-9364-2.
@article{osti_22756224,
title = {Dynamic Investment and Counterparty Risk},
author = {Bo, Lijun and Capponi, Agostino},
abstractNote = {We introduce a dynamic optimization framework in which collateral is used to mitigate losses arising at counterparty’s default. The investor faces two sources of risk: the default risk of the entity referencing the traded credit swap security, and counterparty risk generated from the default event of the trading counterparty. We show that the value function of the control problem coincides with the classical solution of a nonlinear dynamic programming equation. We provide an explicit characterization of the optimal investment strategy, and show that the investor does not trade if counterparty risk is sufficiently high. These findings suggest that moving credit swap trades into well-designed clearinghouses may stimulate economic activities.},
doi = {10.1007/S00245-016-9364-2},
journal = {Applied Mathematics and Optimization},
issn = {0095-4616},
number = 1,
volume = 77,
place = {United States},
year = {2018},
month = {2}
}