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Dynamic Hedging of Portfolio Credit Risk in a Markov Copula Model (Previous title: Dynamic Modeling of Portfolio Credit Risk with Common Shocks)

  • Bielecki, Tomasz R.

    (Illinois Institute of Technology and Université Lyon 1)

  • Cousin, Areski

    (Université d'Évry Val d'Essonne)

  • Crépey, Stéphane

    (Université d'Évry Val d'Essonne)

  • Herbertsson, Alexander

    ()

    (Department of Economics, School of Business, Economics and Law, Göteborg University)

Registered author(s):

    We 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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    File URL: http://hdl.handle.net/2077/25503
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    Paper provided by University of Gothenburg, Department of Economics in its series Working Papers in Economics with number 502.

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    Length: 45 pages
    Date of creation: 18 May 2011
    Date of revision: 12 Oct 2012
    Handle: RePEc:hhs:gunwpe:0502
    Contact details of provider: 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/

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    1. Alexander Herbertsson, 2011. "Modelling default contagion using multivariate phase-type distributions," Review of Derivatives Research, Springer, vol. 14(1), pages 1-36, April.
    2. Rama Cont & Yu Hang Kan, 2011. "Dynamic hedging of portfolio credit derivatives," Post-Print hal-00578008, HAL.
    3. 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.
    4. 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.
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