PRICING AND HEDGING IN A DYNAMIC CREDIT MODEL

Youssef Elouerkhaoui ()
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Youssef Elouerkhaoui: CITIGROUP, Canada Square, Canary Wharf, London E14 5LB, United Kingdom

International Journal of Theoretical and Applied Finance (IJTAF), 2007, vol. 10, issue 04, 703-731

Abstract: In this paper, we present a methodology for pricing and hedging portfolio credit derivatives in a dynamic credit model. Starting with a single-name Marshall–Olkin framework, we build a dynamic top-down version of the model, which is tractable and preserves the intuition of the original setting. In the first part of the paper, we derive analytically the Fourier transform of the loss variable and we study the skew dynamics implied by the model. In the second part, we develop a theory for dynamic hedging of portfolio credit derivatives. Since the market is incomplete, due to the residual correlation risk, perfect replication cannot be achieved. To find the hedging strategies, we use a quadratic risk minimization criterion.

Keywords: Marshall–Olkin model; common poisson shocks; dynamic copula; asymptotic series expansion; top-down approach; forward skew; marked point process; market incompleteness; dynamic hedging; quadratic risk minimization; Föllmer–Sondermann approach (search for similar items in EconPapers)
Date: 2007
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Citations: View citations in EconPapers (13)

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DOI: 10.1142/S0219024907004408

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