Testing Hedges Under the Standard Tranched Credit Pricing Model

Abstract

In the first paper, Christopher Finger presents empirical tests on variations of the standard model for tranched credit derivatives, or synthetic CDOs. There is a rich literature of new model proposals or extensions, but little empirical work focusing on the typical application of the model. Christopher examines a dataset of historical tranche and underlying credit prices, starting from the onset of the credit index tranches as liquid instruments, and including much of the market upheaval of the last year. He performs a backtesting exercise, evaluating the standard model against both simpler and more complex alternatives. This exercise challenges two commonly accepted notions: first, that a sophisticated pricing model is needed to describe the relationship between tranche and underlying, and second, that the standard model can be extended to provide useful hedging information. While the standard model does stand up to the first challenge, its extensions fail on the second.

JEL Classification: G10