Abstract: Since 2018, default events occurred frequently in the Chinese bond market. In this context, Credit Risk Mitigation Warrants (CRMW), sometimes called Chinese credit default swaps(CDS), was issued by the inter-banks bond market in China in 2018. The measurement of CRMW risk mitigation ability and the application of CRMW in the bond portfolio become the key issues to be solved urgently. The reduced model is introduced to measure the default probability of underlying bond, and the default intensity is driven by a two-factor CIR process. Applying State-space model and Kalman filter approaches, the related parameters of the CIR process are estimated according to a time series of historical prices of bonds and risk-free rate. Invoked by CVaR theory, the Default Risk Mitigation Utility (DRMU) of a CRMW is proposed to measure the ability that CRMW mitigates the default risk of underlying bond, and the dynamic risk of bonds with probability quantile is introduced. Given a tracking benchmark, the target of dynamic risk mitigation, a portfolio optimization policy is developed to reasonably utilize CRMW. Using the market data of CRMW and its underlying bonds, the behavior of the optimal portfolio is analyzed. The experiment results show that the optimized portfolio possesses a desired performance for different β quantile and a reasonable risk transfer ratio α, that is, under the premise of guaranteeing the investment return target, the optimal portfolio can achieve the target of dynamic risk mitigation. In addition, the portfolio optimization policy shows a better anti-risk performance. The higher the risk in the scenario, the more robust the optimized portfolio will be. Therefore, the proposed method in this paper can effectively measures the ability of CRMW to mitigate the default risk of underlying bonds,and provides an optimized portfolio strategy to mitigate the default risk of underlying bonds by using CRMW.

Key words: bond market; CRMW; default risk mitigation utility; portfolio optimization strategy