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Hedging structured credit products during the credit crisis: A horse race of 10 models


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  • Ascheberg, Marius
  • Bick, Björn
  • Kraft, Holger
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    Pricing and hedging structured credit products poses major challenges to financial institutions. This paper puts several valuation approaches through a crucial test: How did these models perform in one of the worst periods of economic history, September 2008, when Lehman Brothers went under? Did they produce reasonable hedging strategies? We study several bottom-up and top-down credit portfolio models and compute the resulting delta hedging strategies using either index contracts or a portfolio of single-name CDS contracts as hedging instruments. We compute the profit-and-loss profiles and assess the performances of these hedging strategies. Among all 10 pricing models that we consider the Student-t copula model performs best. The dynamical generalized-Poisson loss model is the best top-down model, but this model class has in general problems to hedge equity tranches. Our major finding is however that single-name and index CDS contracts are not appropriate instruments to hedge CDO tranches.

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    Bibliographic Info

    Article provided by Elsevier in its journal Journal of Banking & Finance.

    Volume (Year): 37 (2013)
    Issue (Month): 5 ()
    Pages: 1687-1705

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    Handle: RePEc:eee:jbfina:v:37:y:2013:i:5:p:1687-1705

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    Keywords: Structured products; P&L analysis; Hedging; Bottom-up models; Top-down models; Copulas; Self-exciting models;

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    1. Ederington, Louis H, 1979. "The Hedging Performance of the New Futures Markets," Journal of Finance, American Finance Association, vol. 34(1), pages 157-70, March.
    2. Igor Halperin & Pascal Tomecek, 2009. "Climbing Down from the Top: Single Name Dynamics in Credit Top Down Models," Papers 0901.3404,
    3. Charles Quanwei Cao & Gurdip S. Bakshi & Zhiwu Chen, 1997. "Empirical Performance of Alternative Option Pricing Models," Yale School of Management Working Papers ysm54, Yale School of Management.
    4. Francis A. Longstaff & Arvind Rajan, 2006. "An Empirical Analysis of the Pricing of Collateralized Debt Obligations," NBER Working Papers 12210, National Bureau of Economic Research, Inc.
    5. Charles Quanwei Cao & Gurdip S. Bakshi & Zhiwu Chen, 1997. "Empirical Performance of Alternative Option Pricing Models," Yale School of Management Working Papers ysm65, Yale School of Management.
    6. Darrell Duffie & Jun Pan & Kenneth Singleton, 2000. "Transform Analysis and Asset Pricing for Affine Jump-Diffusions," Econometrica, Econometric Society, vol. 68(6), pages 1343-1376, November.
    7. Bakshi, Gurdip & Cao, Charles & Chen, Zhiwu, 1997. " Empirical Performance of Alternative Option Pricing Models," Journal of Finance, American Finance Association, vol. 52(5), pages 2003-49, December.
    8. Lutz Schloegl & Dominic O’Kane, 2005. "A note on the large homogeneous portfolio approximation with the Student-t copula," Finance and Stochastics, Springer, vol. 9(4), pages 577-584, October.
    9. Instefjord, Norvald, 2005. "Risk and hedging: Do credit derivatives increase bank risk?," Journal of Banking & Finance, Elsevier, vol. 29(2), pages 333-345, February.
    10. Rama Cont & Yu Hang Kan, 2011. "Dynamic hedging of portfolio credit derivatives," Post-Print hal-00578008, HAL.
    11. Stephan Höcht & Rudi Zagst, 2010. "Pricing distressed CDOs with stochastic recovery," Review of Derivatives Research, Springer, vol. 13(3), pages 219-244, October.
    12. Viktoriya Masol & Wim Schoutens, 2011. "Comparing alternative Levy base correlation models for pricing and hedging CDO tranches," Quantitative Finance, Taylor & Francis Journals, vol. 11(5), pages 763-773.
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