Affine Pricing and Hedging of Collateralized Debt Obligations

Zehra Eksi and Damir Filipović
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Zehra Eksi: Vienna University of Economics and Business, Institute for Statistics and Mathematics
Damir Filipović: Ecole Polytechnique Fédérale de Lausanne; Swiss Finance Institute

No 20-94, Swiss Finance Institute Research Paper Series from Swiss Finance Institute

Abstract: This study deals with the pricing and hedging of single-tranche collateralized debt obligations (STCDOs). We specify an affine two-factor model in which a catastrophic risk component is incorporated. Apart from being analytically tractable, this model has the feature that it captures the dynamics of super-senior tranches, thanks to the catastrophic component. We estimate the factor model based on the iTraxx Europe data with six tranches and four different maturities, using a quasi-maximum likelihood (QML) approach in conjunction with the Kalman filter. We derive the model-based variance-minimizing strategy for the hedging of STCDOs with a dynamically rebalanced portfolio on the underlying swap index. We analyze the actual performance of the variance-minimizing hedge on the iTraxx Europe data. In order to assess the hedging performance further, we run a simulation analysis where normal and extreme loss scenarios are generated via the method of importance sampling. Both in-sample hedging and simulation analysis suggest that the variance-minimizing strategy is most effective for mezzanine tranches in terms of yielding less riskier hedging portfolios and it fails to provide adequate hedge performance regarding equity tranches.

Keywords: single-tranche CDO; affine term-structure of credit spreads; catastrophic risk; variance minimizing hedge (search for similar items in EconPapers)
Pages: 35 pages
Date: 2020-11
New Economics Papers: this item is included in nep-rmg
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Persistent link: https://EconPapers.repec.org/RePEc:chf:rpseri:rp2094

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