On Dynamic Hedging of Single-Tranche Collateralized Debt Obligations

31 Pages Posted: 12 Apr 2013

See all articles by Zehra Eksi

Zehra Eksi

Vienna University of Economics and Business, Institute for Statistics and Mathematics

Damir Filipović

Ecole Polytechnique Fédérale de Lausanne; Swiss Finance Institute

Date Written: April 11, 2013

Abstract

This study deals with the dynamic hedging of single-tranche collateralized debt obligations (STCDOs). As a first step, we specify a top-down affine factor model in which a catastrophic risk component is incorporated in order to capture the dynamics of super-senior tranches. Next, we derive the model-based variance-minimizing strategy for the hedging of STCDOs with a dynamically rebalanced portfolio on the underlying index swap. We analyze the actual performance of the variance-minimizing and the model-free regression-based hedging on the iTraxx Europe data. Results of the in-sample hedging analysis indicate that the regression-based hedge outperforms the variance-minimizing hedge based on various criteria. In order to assess the two hedging strategies further, we run a simulation analysis where normal and extreme loss scenarios are generated via the method of importance sampling. Performing the hedging analysis on the set of simulated scenarios we find that, overall, the variance-minimizing strategy is more effective in terms of yielding less riskier hedging portfolios.

Keywords: single-tranche CDO, affine term-structure of credit spreads, catastrophic risk, variance-minimizing hedge, regression-based hedge

JEL Classification: C51, G12

Suggested Citation

Eksi, Zehra and Filipovic, Damir, On Dynamic Hedging of Single-Tranche Collateralized Debt Obligations (April 11, 2013). Swiss Finance Institute Research Paper No. 13-18. Available at SSRN: https://ssrn.com/abstract=2248666 or http://dx.doi.org/10.2139/ssrn.2248666

Zehra Eksi

Vienna University of Economics and Business, Institute for Statistics and Mathematics ( email )

Welthandelsplatz 1
Building D4, 4th floor
Vienna, 1020
Austria

Damir Filipovic (Contact Author)

Ecole Polytechnique Fédérale de Lausanne ( email )

Odyssea
Station 5
Lausanne, 1015
Switzerland

HOME PAGE: http://people.epfl.ch/damir.filipovic

Swiss Finance Institute

c/o University of Geneva
40, Bd du Pont-d'Arve
CH-1211 Geneva 4
Switzerland

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