Dynamic CDO Pricing and Hedging in a Forward Setting

Abstract

Dynamic CDO modeling became a hot topic prior to the crisis. The latter, however, showed clearly the inadequacy of static models based on Gaussian copula for pricing, hedging, and risk management. Further, the financial innovation in the market fueled a demand for dynamic models that can capture in a consistent way the default, spread, correlation, contagion, diversification, and recovery effects arising in the basket credit derivatives segment. Encompassing all of them in a tractable arbitrage free model happened to be a highly non-trivial task and posed a big challenge both to practitioners and academics. The purpose of the paper is to address the open problems from the maturity of the post-crisis environment and provide a possible analytic toolkit with a view towards the expected new development of the credit correlation segment. Employing the general HJM forward abstract setting of Sidenius, Piterbarg, and Andersen (2008) as a workhorse, we modify and upgrade it appropriately so that all of the above mentioned effects are incorporated. Then the focus is turned to pricing and hedging. Formal pricing rules are derived and different hedging strategies are discussed. The model is calibrated to market data and its hedging performance is analyzed.

Keywords: CDO, tranche, dependence, forward rate, hedging

JEL Classification: G01, G13