Equity and CDS Sector Indices: Dynamic Models and Risk Hedging

Abstract

The recent financial crisis had a substantial impact on equity and bond markets, as well as on the performances of managed portfolios which have been hit by the decrease of both indices. Nevertheless, the availability of indices monitoring the equity market volatility, the VIX index, credit markets default risk, and CDS indices, allows for the construction of hedging strategies. In this paper, we take the point of view of an equity investor who wants to hedge the equity risk by taking positions either on the VIX index or on CDS indices. In deriving the hedge ratios, we consider the joint dynamic of variables taking into account mean relations, variance spillovers, and asymmetry, as well as correlation changes over time. Our analysis is based on sectorial indices and shows the advantages of hedging and the impact of a model specification.

Keywords: optimal hedge ratios, equity risk hedging, bond risk, CDS index, VIX index, economic sectors

JEL Classification: C32, C53, C58, G11