Basis Risk in Hedging a CDS Portfolio with Credit Indices

Abstract

The financial crisis has raised concerns throughout the industry on the possibility that hedging credit valuation adjustment (CVA) might become increasingly difficult should the long-standing correlation between singlename and index CDS products break down. So, we provide an estimation of the basis risk that arises when hedging credit portfolios with different credit indices, to answer the following questions: Is there enough diversification of risk in a global credit portfolio to allow for a good hedge? Is basis risk higher in North America than in Europe? Does the effectiveness of the hedge increase when we consider more than one index to hedge the portfolio? Is the hedge based on conditional moments to be preferred to the least squares hedge?

Keywords: CDS, Credit Indices, Credit Hedge, Basis Risk

JEL Classification: G01, G12, G13, G14, G15