Dynamic hedging of portfolio credit derivatives
AbstractWe 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.
Download InfoIf you experience problems downloading a file, check if you have the proper application to view it first. In case of further problems read the IDEAS help page. Note that these files are not on the IDEAS site. Please be patient as the files may be large.
Bibliographic InfoPaper provided by HAL in its series Post-Print with number hal-00578008.
Date of creation: 01 Feb 2011
Date of revision:
Publication status: Published, SIAM Journal on Financial Mathematics, 2011, 2, 1, 112-140
Note: View the original document on HAL open archive server: http://hal.archives-ouvertes.fr/hal-00578008/en/
Contact details of provider:
Web page: http://hal.archives-ouvertes.fr/
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;
This paper has been announced in the following NEP Reports:
- NEP-ALL-2011-03-26 (All new papers)
- NEP-BAN-2011-03-26 (Banking)
- NEP-FMK-2011-03-26 (Financial Markets)
- NEP-RMG-2011-03-26 (Risk Management)
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.:
- 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.
- Areski Cousin & Stéphane Crépey & Yu Kan, 2012. "Delta-hedging correlation risk?," Review of Derivatives Research, Springer, vol. 15(1), pages 25-56, April.
For technical questions regarding this item, or to correct its authors, title, abstract, bibliographic or download information, contact: (CCSD).
If references are entirely missing, you can add them using this form.