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Dynamic Hedging of Portfolio Credit Derivatives

27 Pages Posted: 26 Feb 2009 Last revised: 7 Dec 2009

Rama Cont

Imperial College London; CNRS; Norges Bank Research

Yu Hang (Gabriel) Kan

Bloomberg Tradebook; Columbia University - Department of Industrial Engineering and Operations Research (IEOR)

Date Written: September 29, 2008

Abstract

We compare the performance of various hedging strategies for index 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 the risk in CDO tranches appears to be unhedgeable. We also show that, unlike what is commonly assumed, dynamic models do not necessarily perform better the static models, nor do high-dimensional bottom-up models perform better than simpler top-down models. Moreover, top-down and regression-based hedging would have provided significantly better hedges than bottom-up hedging with single name CDS during the Lehman Brothers default event. Our empirical study also reveals that while significantly large moves - "jumps" - do occur in the CDS, index and tranche spreads, these jumps do not necessarily occur on default dates of index constituents, an observation which contradicts the intuition conveyed by some recently proposed credit risk models.

Keywords: hedging, portfolio credit derivatives, index default swaps, collateralized debt obligations, top-down credit risk models, default contagion, spread risk, sensitivity-based hedging, risk minimization

JEL Classification: G13, G12

Suggested Citation

Cont, Rama and Kan, Yu Hang (Gabriel), Dynamic Hedging of Portfolio Credit Derivatives (September 29, 2008). Available at SSRN: https://ssrn.com/abstract=1349847 or http://dx.doi.org/10.2139/ssrn.1349847

Rama Cont (Contact Author)

Imperial College London ( email )

London, SW7 2AZ
United Kingdom

HOME PAGE: http://www3.imperial.ac.uk/people/r.cont

CNRS ( email )

Laboratoire de Probabilites & Modeles aleatoires
Universite Pierre & Marie Curie (Paris VI)
Paris, 75252
France

HOME PAGE: http://rama.cont.perso.math.cnrs.fr/

Norges Bank Research ( email )

P.O. Box 1179
Oslo, N-0107
Norway

Yu Hang Kan

Bloomberg Tradebook ( email )

731 Lexington Avenue
New York, NY 10022
United States

Columbia University - Department of Industrial Engineering and Operations Research (IEOR) ( email )

331 S.W. Mudd Building
500 West 120th Street
New York, NY 10027
United States

HOME PAGE: http://www.columbia.edu/~yk2246

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