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Dynamic hedging of synthetic CDO tranches with spread risk and default contagion

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  • Frey, Rüdiger
  • Backhaus, Jochen
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    Abstract

    The paper is concerned with the hedging of credit derivatives, in particular synthetic CDO tranches, in a dynamic portfolio credit risk model with spread risk and default contagion. The model is constructed and studied via Markov-chain techniques. We discuss the immunization of a CDO tranche against spread- and event risk in the Markov-chain model and compare the results with market-standard hedge ratios obtained in a Gauss copula model. In the main part of the paper we derive model-based dynamic hedging strategies and study their properties in numerical experiments.

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    Bibliographic Info

    Article provided by Elsevier in its journal Journal of Economic Dynamics and Control.

    Volume (Year): 34 (2010)
    Issue (Month): 4 (April)
    Pages: 710-724

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    Handle: RePEc:eee:dyncon:v:34:y:2010:i:4:p:710-724

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    Web page: http://www.elsevier.com/locate/jedc

    Related research

    Keywords: Dynamic hedging Portfolio credit risk Credit derivatives Incomplete markets Default contagion;

    References

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    Please report citation or reference errors to , or , if you are the registered author of the cited work, log in to your RePEc Author Service profile, click on "citations" and make appropriate adjustments.:
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    1. Giesecke, Kay & Weber, Stefan, 2006. "Credit contagion and aggregate losses," Journal of Economic Dynamics and Control, Elsevier, vol. 30(5), pages 741-767, May.
    2. Colwell, David & El-Hassan, Nadima & Kang Kwon, Oh, 2007. "Hedging diffusion processes by local risk minimization with applications to index tracking," Journal of Economic Dynamics and Control, Elsevier, vol. 31(7), pages 2135-2151, July.
    3. Robert A. Jarrow, 2001. "Counterparty Risk and the Pricing of Defaultable Securities," Journal of Finance, American Finance Association, vol. 56(5), pages 1765-1799, October.
    4. Rüdiger Frey & Jochen Backhaus, 2008. "Pricing And Hedging Of Portfolio Credit Derivatives With Interacting Default Intensities," International Journal of Theoretical and Applied Finance (IJTAF), World Scientific Publishing Co. Pte. Ltd., vol. 11(06), pages 611-634.
    5. Rosen, Dan & Saunders, David, 2009. "Analytical methods for hedging systematic credit risk with linear factor portfolios," Journal of Economic Dynamics and Control, Elsevier, vol. 33(1), pages 37-52, January.
    6. Nicole El Karoui & Monique Jeanblanc-Picquè & Steven E. Shreve, 1998. "Robustness of the Black and Scholes Formula," Mathematical Finance, Wiley Blackwell, vol. 8(2), pages 93-126.
    7. M. Davis & V. Lo, 2001. "Infectious defaults," Quantitative Finance, Taylor & Francis Journals, vol. 1(4), pages 382-387.
    8. Stefan Weber & Kay Giesecke, 2003. "Credit Contagion and Aggregate Losses," Computing in Economics and Finance 2003 246, Society for Computational Economics.
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    Cited by:
    1. Rüdiger Frey & Thorsten Schmidt, 2012. "Pricing and hedging of credit derivatives via the innovations approach to nonlinear filtering," Finance and Stochastics, Springer, vol. 16(1), pages 105-133, January.

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