Dynamic Hedging of Synthetic CDO Tranches with Spread Risk and Default Contagion
by Rüdiger Frey of the Universität Leipzig, and
October 6, 2009
Abstract: The paper is concerned with the hedging of credit derivatives, in particular synthetic CDO tranches, in a dynamic portfolio credit risk model with 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 market-standard hedge ratios obtained in a Gauss copula model. In the main part of the paper we derive model-based dynamic hedging strategies and study their properties in numerical experiments.
Keywords: Dynamic hedging, portfolio credit risk, credit derivatives, incomplete markets, default contagion.
Published in: Journal of Economic Dynamics and Control, Vol. 34, No. 4, (April 2010), pp. 710-724.
Previously titled: Dynamic Hedging of Synthetic CDO Tranches with Spread- and Contagion Risk