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Dynamic hedging of portfolio credit derivatives

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Author Info

  • Rama Cont

    () (PMA - Laboratoire de Probabilités et Modèles Aléatoires - CNRS : UMR7599 - Université Pierre et Marie Curie - Paris VI - Université Paris-Diderot - Paris VII, IEOR Department (Industrial Engineering & Operations Research) - Columbia University)

  • Yu Hang Kan

    (IEOR Department (Industrial Engineering & Operations Research) - Columbia University)

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    Abstract

    We compare the performance of various hedging strategies for index collateralized debt obligation (CDO) tranches across a variety of models and hedging methods during the recent credit crisis. Our empirical analysis shows evidence for market incompleteness: a large proportion of risk in the CDO tranches appears to be unhedgeable. We also show that, unlike what is commonly assumed, dynamic models do not necessarily perform better than static models, nor do high-dimensional bottom-up models perform better than simpler top-down models. When it comes to hedging, top-down and regression-based hedging with the index provide significantly better results during the credit crisis than bottom-up hedging with single-name credit default swap (CDS) contracts. Our empirical study also reveals that while significantly large moves—“jumps”—do occur in CDS, index, and tranche spreads, these jumps do not necessarily occur on the default dates of index constituents, an observation which shows the insufficiency of some recently proposed portfolio credit risk models.

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    File URL: http://hal.archives-ouvertes.fr/docs/00/57/80/08/PDF/CDOHedgeSIAM2011.pdf
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    Bibliographic Info

    Paper provided by HAL in its series Post-Print with number hal-00578008.

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    Date of creation: 01 Feb 2011
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    Publication status: Published, SIAM Journal on Financial Mathematics, 2011, 2, 1, 112-140
    Handle: RePEc:hal:journl:hal-00578008

    Note: View the original document on HAL open archive server: http://hal.archives-ouvertes.fr/hal-00578008/en/
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    Web page: http://hal.archives-ouvertes.fr/

    Related research

    Keywords: hedging; credit default swaps; portfolio credit derivatives; index default swaps; collateralized debt obligations; portfolio credit risk models; default contagion; spread risk; sensitivity-based hedging; variance minimization;

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    References

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    1. Massimo Morini & Damiano Brigo, 2008. "Arbitrage-free Pricing of Credit Index Options: The no-armageddon pricing measure and the role of correlation after the subprime crisis," Papers 0812.4156, arXiv.org.
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    Cited by:
    1. Areski Cousin & Stéphane Crépey & Yu Kan, 2012. "Delta-hedging correlation risk?," Review of Derivatives Research, Springer, vol. 15(1), pages 25-56, April.

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