Basis Risk When Hedging a Global Credit Portfolio

Abstract

We examine the efficiency of hedging a credit derivative portfolio with a contrary position in a credit index in the face of decreased correlations between single name CDSs and credit indices. The interest of such hedge comes from the fact that the calculation of the capital charge for CVA risk, as required by the Basel Committee on Banking Supervision, is usually rather unstable due to the volatility of CDS spreads. Since credit derivatives on single names are not very liquid, the implied adjustments in capital charges could be reduced by the mentioned hedging strategy, and we show that there is enough diversification of risk in a global credit portfolio to allow for a good hedge. Over the whole sample, the reduction in the variance of the portfolio’s profit and losses (P&L) is of 80% for a European portfolio, 60% for North American and Japanese portfolios, and around 70% for a global portfolio. Using a strategy that takes into account the quality of the credit counterpart improves the effectiveness of the hedge, although it requires using less liquid credit indices, with higher transaction costs. Standard conditional volatility models provide the same results as a least squares hedge. The efficiency of the hedge for a credit portfolio made up of the most idiosyncratic firms seems to require more than 50 firms, while the hedge for portfolios made up of the less idiosyncratic firms achieves high efficiency even for a small number of firms. The efficiency of the hedge is higher when portfolio volatility is high and also when short term interest rates or exchange rate volatility are high. Increases in VIX, in the 10-year swap rate or in liquidity risk tend to decrease hedging efficiency.