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Dynamic hedging of portfolio credit derivatives

Rama Cont () and Yu Hang Kan
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Rama Cont: LPMA - Laboratoire de Probabilités et Modèles Aléatoires - UPMC - Université Pierre et Marie Curie - Paris 6 - UPD7 - Université Paris Diderot - Paris 7 - CNRS - Centre National de la Recherche Scientifique, IEOR Department (Industrial Engineering & Operations Research) - Columbia University [New York]
Yu Hang Kan: IEOR Department (Industrial Engineering & Operations Research) - Columbia University [New York]

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Abstract: We compare the performance of various hedging strategies for index collateralized debt obligation (CDO) tranches across a variety of models and hedging methods during the recent credit crisis. Our empirical analysis shows evidence for market incompleteness: a large proportion of risk in the CDO tranches appears to be unhedgeable. We also show that, unlike what is commonly assumed, dynamic models do not necessarily perform better than static models, nor do high-dimensional bottom-up models perform better than simpler top-down models. When it comes to hedging, top-down and regression-based hedging with the index provide significantly better results during the credit crisis than bottom-up hedging with single-name credit default swap (CDS) contracts. Our empirical study also reveals that while significantly large moves—"jumps"—do occur in CDS, index, and tranche spreads, these jumps do not necessarily occur on the default dates of index constituents, an observation which shows the insufficiency of some recently proposed portfolio credit risk models.

Keywords: hedging; credit default swaps; portfolio credit derivatives; index default swaps; collateralized debt obligations; portfolio credit risk models; default contagion; spread risk; sensitivity-based hedging; variance minimization (search for similar items in EconPapers)
Date: 2011-02-01
New Economics Papers: this item is included in nep-ban, nep-fmk and nep-rmg
Note: View the original document on HAL open archive server: https://hal.science/hal-00578008
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Published in SIAM Journal on Financial Mathematics, 2011, 2 (1), pp.112-140. ⟨10.1137/090750937⟩

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Persistent link: https://EconPapers.repec.org/RePEc:hal:journl:hal-00578008

DOI: 10.1137/090750937

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