Dynamic hedging of portfolio credit derivatives
We 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.
|Date of creation:||01 Feb 2011|
|Publication status:||Published in SIAM Journal on Financial Mathematics, SIAM, 2011, 2 (1), pp.112-140. <10.1137/090750937>|
|Note:||View the original document on HAL open archive server: https://hal.archives-ouvertes.fr/hal-00578008|
|Contact details of provider:|| Web page: https://hal.archives-ouvertes.fr/|
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- 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.
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