On Dynamic Hedging of Single-Tranche Collateralized Debt Obligations

This study deals with the dynamic hedging of single-tranche collateralized debt obligations (STCDOs). As a first step, we specify a top-down affine factor model in which a catastrophic risk component is incorporated in order to capture the dynamics of super-senior tranches. Next, we derive the model-based variance-minimizing strategy for the hedging of STCDOs with a dynamically rebalanced portfolio on the underlying index swap. We analyze the actual performance of the variance-minimizing and the model-free regression-based hedging on the iTraxx Europe data. Results of the in-sample hedging analysis indicate that the regression-based hedge outperforms the variance-minimizing hedge based on various criteria. In order to assess the two hedging strategies further, we run a simulation analysis where normal and extreme loss scenarios are generated via the method of importance sampling. Performing the hedging analysis on the set of simulated scenarios we find that, overall, the variance-minimizing strategy is more effective in terms of yielding less riskier hedging portfolios.