DYNAMIC PORTFOLIO OPTIMIZATION WITH A DEFAULTABLE SECURITY AND REGIME‐SWITCHING

We consider a portfolio optimization problem in a defaultable market with finitely‐many economical regimes, where the investor can dynamically allocate her wealth among a defaultable bond, a stock, and a money market account. The market coefficients are assumed to depend on the market regime in place, which is modeled by a finite state continuous time Markov process. By separating the utility maximization problem into a predefault and postdefault component, we deduce two coupled Hamilton–Jacobi–Bellman equations for the post‐ and predefault optimal value functions, and show a novel verification theorem for their solutions. We obtain explicit constructions of value functions and investment strategies for investors with logarithmic and Constant Relative Risk Aversion utilities, and provide a precise characterization of the directionality of the bond investment strategies in terms of corporate returns, forward rates, and expected recovery at default. We illustrate the dependence of the optimal strategies on time, losses given default, and risk aversion level of the investor through a detailed economic and numerical analysis.