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Analytical methods for hedging systematic credit risk with linear factor portfolios

  • Rosen, Dan
  • Saunders, David
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    Multi-factor credit portfolio models are used widely today for managing economic capital and pricing collateralized debt obligations (CDOs) and asset-backed securities. Commonly, practitioners allocate capital to the portfolio components (sub-portfolios, counterparties, or transactions). The hedging of credit risk is generally also focused on the 'deltas' of underlying names. We present analytical results for hedging portfolio credit risk with linear combinations of systematic factors, based on the minimization of systematic variance of portfolio losses. We solve these problems within a multi-factor Merton-type credit portfolio model, and apply them to hedge systematic credit default losses of loan portfolios and CDOs.

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    File URL: http://www.sciencedirect.com/science/article/B6V85-4SJP78T-2/2/ebf51a44c23689c8745d22a7e8670945
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    Article provided by Elsevier in its journal Journal of Economic Dynamics and Control.

    Volume (Year): 33 (2009)
    Issue (Month): 1 (January)
    Pages: 37-52

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    Handle: RePEc:eee:dyncon:v:33:y:2009:i:1:p:37-52
    Contact details of provider: Web page: http://www.elsevier.com/locate/jedc

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    1. Gourieroux, C. & Laurent, J. P. & Scaillet, O., 2000. "Sensitivity analysis of Values at Risk," Journal of Empirical Finance, Elsevier, vol. 7(3-4), pages 225-245, November.
    2. Dirk Tasche, 2001. "Conditional Expectation as Quantile Derivative," Papers math/0104190, arXiv.org.
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    4. Sanjiv R. Das & Darrell Duffie & Nikunj Kapadia & Leandro Saita, 2007. "Common Failings: How Corporate Defaults Are Correlated," Journal of Finance, American Finance Association, vol. 62(1), pages 93-117, 02.
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    6. Christian Gourieroux & Jean-Paul Laurent & Olivier Scaillet, 2000. "Sensitivity Analysis of Values at Risk," Working Papers 2000-05, Centre de Recherche en Economie et Statistique.
    7. Merton, Robert C, 1974. "On the Pricing of Corporate Debt: The Risk Structure of Interest Rates," Journal of Finance, American Finance Association, vol. 29(2), pages 449-70, May.
    8. Gordy, Michael B., 2003. "A risk-factor model foundation for ratings-based bank capital rules," Journal of Financial Intermediation, Elsevier, vol. 12(3), pages 199-232, July.
    9. Kreinin, Alexander & Nagi, Ahmed, 2008. "Calibration of the default probability model," European Journal of Operational Research, Elsevier, vol. 185(3), pages 1462-1476, March.
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