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Dynamic hedging of synthetic CDO tranches with spread risk and default contagion

  • Frey, Rüdiger
  • Backhaus, Jochen
Registered author(s):

    The paper is concerned with the hedging of credit derivatives, in particular synthetic CDO tranches, in a dynamic portfolio credit risk model with spread risk and default contagion. The model is constructed and studied via Markov-chain techniques. We discuss the immunization of a CDO tranche against spread- and event risk in the Markov-chain model and compare the results with market-standard hedge ratios obtained in a Gauss copula model. In the main part of the paper we derive model-based dynamic hedging strategies and study their properties in numerical experiments.

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    File URL: http://www.sciencedirect.com/science/article/B6V85-4XJ17KT-1/2/0526928ef1ceabd8691fdc2c6830c7af
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    Article provided by Elsevier in its journal Journal of Economic Dynamics and Control.

    Volume (Year): 34 (2010)
    Issue (Month): 4 (April)
    Pages: 710-724

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    Handle: RePEc:eee:dyncon:v:34:y:2010:i:4:p:710-724
    Contact details of provider: Web page: http://www.elsevier.com/locate/jedc

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    1. M. Davis & V. Lo, 2001. "Infectious defaults," Quantitative Finance, Taylor & Francis Journals, vol. 1(4), pages 382-387.
    2. 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.
    3. Nicole El Karoui & Monique Jeanblanc-Picquè & Steven E. Shreve, 1998. "Robustness of the Black and Scholes Formula," Mathematical Finance, Wiley Blackwell, vol. 8(2), pages 93-126.
    4. Giesecke, Kay & Weber, Stefan, 2006. "Credit contagion and aggregate losses," Journal of Economic Dynamics and Control, Elsevier, vol. 30(5), pages 741-767, May.
    5. Colwell, David & El-Hassan, Nadima & Kang Kwon, Oh, 2007. "Hedging diffusion processes by local risk minimization with applications to index tracking," Journal of Economic Dynamics and Control, Elsevier, vol. 31(7), pages 2135-2151, July.
    6. Stefan Weber & Kay Giesecke, 2003. "Credit Contagion and Aggregate Losses," Computing in Economics and Finance 2003 246, Society for Computational Economics.
    7. Rüdiger Frey & Jochen Backhaus, 2008. "Pricing And Hedging Of Portfolio Credit Derivatives With Interacting Default Intensities," International Journal of Theoretical and Applied Finance (IJTAF), World Scientific Publishing Co. Pte. Ltd., vol. 11(06), pages 611-634.
    8. Robert A. Jarrow, 2001. "Counterparty Risk and the Pricing of Defaultable Securities," Journal of Finance, American Finance Association, vol. 56(5), pages 1765-1799, October.
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