Dynamic Hedging of Portfolio Credit Risk in a Markov Copula Model (Previous title: Dynamic Modeling of Portfolio Credit Risk with Common Shocks)
AbstractWe consider a bottom-up Markovian copula model of portfolio credit risk where dependence among credit names mainly stems from the possibility of simultaneous defaults. Due to the Markovian copula nature of the model, calibration of marginals and dependence parameters can be performed separately using a two-steps procedure, much like in a standard static copula set-up. In addition, the model admits a common shocks interpretation, which is a very important feature as, thanks to it, efficient convolution recursion procedures are available for pricing and hedging CDO tranches, conditionally on any given state of the underlying multivariate Markov process. As a result this model allows us to dynamically hedge CDO tranches using single-name CDSs in a theoretically sound and practically convenient way. To illustrate this we calibrate the model against market data on CDO tranches and the underlying single-name CDSs. We then study the loss distributions as well as the min-variance hedging strategies in the calibrated portfolios.
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Bibliographic InfoPaper provided by University of Gothenburg, Department of Economics in its series Working Papers in Economics with number 502.
Length: 45 pages
Date of creation: 18 May 2011
Date of revision: 12 Oct 2012
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Postal: Department of Economics, School of Business, Economics and Law, University of Gothenburg, Box 640, SE 405 30 GÖTEBORG, Sweden
Phone: 031-773 10 00
Web page: http://www.handels.gu.se/econ/
More information through EDIRC
Portfolio Credit Risk; Basket Credit Derivatives; Dynamic Min-Variance Hedging; Common Shocks; Markov Copula Model;
Find related papers by JEL classification:
- G11 - Financial Economics - - General Financial Markets - - - Portfolio Choice; Investment Decisions
This paper has been announced in the following NEP Reports:
- NEP-ALL-2012-10-20 (All new papers)
- NEP-BAN-2012-10-20 (Banking)
- NEP-RMG-2012-10-20 (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.:
- Youssef Elouerkhaoui, 2007. "Pricing And Hedging In A Dynamic Credit Model," International Journal of Theoretical and Applied Finance (IJTAF), World Scientific Publishing Co. Pte. Ltd., vol. 10(04), pages 703-731.
- Rama Cont & Yu Hang Kan, 2011. "Dynamic hedging of portfolio credit derivatives," Post-Print hal-00578008, HAL.
- Damiano Brigo & Andrea Pallavicini & Roberto Torresetti, 2007. "Cluster-Based Extension Of The Generalized Poisson Loss Dynamics And Consistency With Single Names," International Journal of Theoretical and Applied Finance (IJTAF), World Scientific Publishing Co. Pte. Ltd., vol. 10(04), pages 607-631.
- Alexander Herbertsson, 2011. "Modelling default contagion using multivariate phase-type distributions," Review of Derivatives Research, Springer, vol. 14(1), pages 1-36, April.
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