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Analytical methods for hedging systematic credit risk with linear factor portfolios

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  • Rosen, Dan
  • Saunders, David

Abstract

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.

Suggested Citation

  • Rosen, Dan & Saunders, David, 2009. "Analytical methods for hedging systematic credit risk with linear factor portfolios," Journal of Economic Dynamics and Control, Elsevier, vol. 33(1), pages 37-52, January.
    • Handle: RePEc:eee:dyncon:v:33:y:2009:i:1:p:37-52
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    References listed on IDEAS

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    Citations

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    Cited by:

    1. Yang, Bill Huajian, 2017. "Forward Ordinal Probability Models for Point-in-Time Probability of Default Term Structure," MPRA Paper 79934, University Library of Munich, Germany.
    2. Alexander Cherny & Raphael Douady & Stanislav Molchanov, 2010. "On measuring nonlinear risk with scarce observations," Finance and Stochastics, Springer, vol. 14(3), pages 375-395, September.
    3. Lee, Yongwoong & Poon, Ser-Huang, 2014. "Forecasting and decomposition of portfolio credit risk using macroeconomic and frailty factors," Journal of Economic Dynamics and Control, Elsevier, vol. 41(C), pages 69-92.
    4. Yang, Bill Huajian, 2017. "Point-in-time PD term structure models for multi-period scenario loss projection: Methodologies and implementations for IFRS 9 ECL and CCAR stress testing," MPRA Paper 76271, University Library of Munich, Germany.
    5. Yang, Bill Huajian, 2014. "Modeling Systematic Risk and Point-in-Time Probability of Default under the Vasicek Asymptotic Single Risk Factor Model Framework," MPRA Paper 59025, University Library of Munich, Germany.
    6. Lindset, Snorre & Lund, Arne-Christian & Persson, Svein-Arne, 2014. "Credit risk and asymmetric information: A simplified approach," Journal of Economic Dynamics and Control, Elsevier, vol. 39(C), pages 98-112.
    7. Yang, Bill Huajian & Wu, Biao & Cui, Kaijie & Du, Zunwei & Fei, Glenn, 2019. "IFRS9 Expected Credit Loss Estimation: Advanced Models for Estimating Portfolio Loss and Weighting Scenario Losses," MPRA Paper 93634, University Library of Munich, Germany.
    8. Rosen, Dan & Saunders, David, 2010. "Risk factor contributions in portfolio credit risk models," Journal of Banking & Finance, Elsevier, vol. 34(2), pages 336-349, February.
    9. Damiano Brigo & Andrea Pallavicini & Roberto Torresetti, 2009. "Credit models and the crisis, or: how I learned to stop worrying and love the CDOs," Papers 0912.5427, arXiv.org, revised Feb 2010.
    10. Lee, Yongwoong & Yang, Kisung, 2019. "Modeling diversification and spillovers of loan portfolios' losses by LHP approximation and copula," International Review of Financial Analysis, Elsevier, vol. 66(C).
    11. Yang, Bill Huajian, 2013. "Estimating Long-Run PD, Asset Correlation, and Portfolio Level PD by Vasicek Models," MPRA Paper 57244, University Library of Munich, Germany.
    12. Yang, Bill Huajian, 2017. "Point-in-Time PD Term Structure Models with Loan Credit Quality as a Component," MPRA Paper 80641, University Library of Munich, Germany.
    13. Yang, Bill Huajian & Du, Zunwei, 2016. "Rating Transition Probability Models and CCAR Stress Testing: Methodologies and implementations," MPRA Paper 76270, University Library of Munich, Germany.
    14. Yang, Bill Huajian & Du, Zunwei, 2015. "Stress Testing and Modeling of Rating Migration under the Vasicek Model Framework - Empirical approaches and technical implementation," MPRA Paper 65168, University Library of Munich, Germany.
    15. Miguel A. Lejeune & Gülay Samatlı-Paç, 2013. "Construction of Risk-Averse Enhanced Index Funds," INFORMS Journal on Computing, INFORMS, vol. 25(4), pages 701-719, November.
    16. Frey, Rüdiger & Backhaus, Jochen, 2010. "Dynamic hedging of synthetic CDO tranches with spread risk and default contagion," Journal of Economic Dynamics and Control, Elsevier, vol. 34(4), pages 710-724, April.
    17. Yang, Bill Huajian, 2019. "Monotonic Estimation for the Survival Probability over a Risk-Rated Portfolio by Discrete-Time Hazard Rate Models," MPRA Paper 93398, University Library of Munich, Germany.
    18. Yang, Bill Huajian & Yang, Jenny & Yang, Haoji, 2020. "Modeling Portfolio Loss by Interval Distributions," MPRA Paper 102219, University Library of Munich, Germany.

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