Rosen, Dan, David Saunders, "Analytical Methods for Hedging Systematic Credit Risk with Linear Factor Portfolios", Journal of Economic Dynamics and Control, Vol. 33, No. 1, (January 2009), pp. 37-52
Abstract: Multi-factor credit portfolio models are used widely today for managing economic capital and pricing collateralized debt obligations (CDOs) and asset-backed securities. Commonly, practitioners allocate capital to the portfolio components (sub-portfolios, counterparties, or transactions). The hedging of credit risk is generally also focused on the 'deltas' of underlying names. We present analytical results for hedging portfolio credit risk with linear combinations of systematic factors, based on the minimization of systematic variance of portfolio losses. We solve these problems within a multi-factor Merton-type credit portfolio model, and apply them to hedge systematic credit default losses of loan portfolios and CDOs.
Keywords: Credit risk, Factor models, Hedging, Capital allocation.