Optimal investment and consumption strategies for an investor with stochastic economic factor in a defaultable market

Abstract

This paper considers the issue of optimal investment and consumption strategies for an investor with stochastic economic factor in a defaultable market. In our model, the price process is composed of a money market account and a default-free risky asset, assuming they rely on a stochastic economic factor described by a diffusion process. A defaultable perpetual bond is depicted by the reduced-form model, and both the default risk premium and the default intensity of it rely on the stochastic economic factor. Our goal is to maximize the infinite horizon expected discounted power utility of the consumption. Applying the dynamic programming principle, we derive the Hamilton–Jacobi–Bellman (HJB) equations and analyze them using the so-called sub-super solution method to prove the existence and uniqueness of their classical solutions. Next, we use a verification theorem to derive the explicit formula for optimal investment and consumption strategies. Finally, we provide a sensitivity analysis.