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A Note on the Risk Management of CDOs

by Jean-Paul Laurent of the Université Lyon 1 & BNP Paribas

February 2007

Abstract: The purpose of this note is to describe a risk management procedure applicable to options on large credit portfolios such as CDO tranches on iTraxx or CDX. Credit spread risks are dynamically hedged using single name defaultable claims while default risk is kept under control thanks to diversification. The proposed risk management approach mixes ideas from finance and insurance and departs from standard approaches used in incomplete markets such as mean-variance hedging or expected utility maximisation. In order to ease the analysis and the exposure, default dates follow a multivariate Cox process.

JEL Classification: G13.

Keywords: CDOs, default risk, credit spread risk, dynamic hedging, incomplete markets, Cox process.

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