Abstract
The hedge effectiveness of the credit default swap (CDS) indices is analyzed. Starting with the CDS eligible for inclusion in the indices, CDX.NA.IG, CDX.NA.HY, iTraxx Europe and iTraxx Xover, a credit portfolio construction algorithm is proposed. It is based on principal components for variable selection. The spectral decomposition defines a deletion criterion that defines alternative portfolios of CDS for comparison to the printed indices. Hedge back testing, quantified as a volatility reduction, indicates that as few as 2 names can replicate the behavior of the traded index. To understand this, the network topology of the CDS is then studied. This shows a ‘market effect’ across the majority of CDS eligible for a specific index, which translates to low information content for these names versus the broader market. The net result is that a small subset of credits captures the price action.
Published Version
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