Dynamic Hedging of Synthetic CDO Tranches with Spread Risk and Default Contagion

by Rüdiger Frey of the Universität Leipzig, and
Jochen Backhaus of the Universität Leipzig

December 17, 2007

Abstract: We study the hedging of synthetic CDO tranches in a dynamic portfolio credit risk model which incorporates spread risk and default contagion. The model is constructed and studied via Markov-chain techniques. We discuss the immunization of a CDO tranche against spread- and event risk in the Markov-chain model and compare the results with hedge ratios obtained in the standard Gauss copula model. Moreover, we derive model-based dynamic hedging strategies using the concept of risk minimization. Numerical experiments are used to illustrate some of the properties of the risk-minimizing hedging strategies.

JEL Classification: G31, G11, C15.

Keywords: Dynamic hedging, portfolio credit risk, credit derivatives, incomplete markets, default contagion.

Previously titled: Dynamic Hedging of Synthetic CDO Tranches with Spread- and Contagion Risk

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Related reading: Understanding and Hedging Risks in Synthetic CDO Tranches

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