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Optimal Allocation Between Subprime Structured Mortgage Products and Treasuries

Authors: MP. Mulaudzi, MA. Petersen, J. Mukuddem-Petersen, IM. Schoeman, B. de Waal, JM. Manale


This conference paper discusses a risk allocation problem for subprime investing banks involving investment in subprime structured mortgage products (SMPs) and Treasuries. In order to solve this problem, we develop a L'evy process-based model of jump diffusion-type for investment choice in subprime SMPs and Treasuries. This model incorporates subprime SMP losses for which credit default insurance in the form of credit default swaps (CDSs) can be purchased. In essence, we solve a mean swap-at-risk (SaR) optimization problem for investment which determines optimal allocation between SMPs and Treasuries subject to credit risk protection via CDSs. In this regard, SaR is indicative of how much protection investors must purchase from swap protection sellers in order to cover possible losses from SMP default. Here, SaR is defined in terms of value-at-risk (VaR). Finally, we provide an analysis of the aforementioned optimization problem and its connections with the subprime mortgage crisis (SMC).

Keywords: credit risk, value-at-risk, counterparty risk, credit default swaps, Investors; Jump Diffusion Process, Structured Mortgage Products, Treasuries, Tranching Risk, Swaps-at-Risk, Subprime Mortgage Crisis

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