Cross-Market Hedging Strategies for Credit Default Swaps under a Markov Regime-Switching Framework

Abstract

This article explores strategies used for hedging credit default swap (CDS) risks. By analyzing the AIG financial crisis in 2008, the authors increase their understanding of the nature of CDSs and why AIG incurred huge losses. In addition, they investigate other financial products that can be used to hedge CDS risks. Complementary to Jarrow [2010] who suggested that government regulation should impose stricter collateral requirements and higher equity capital for CDS traders to minimize CDS seller failure, they provide feasible hedging strategies for CDS sellers instead. The authors contribute to the literature in the following aspects. First, they find that stock returns significantly affect CDS returns, depending on regimes, and their model is able to capture these switching characteristics. Second, they explain how the correlation between CDS and stock returns can be used to adjust hedge ratios based on different regime-switching situations. Finally, they find that high hedge ratios are suitable for firms with low credit quality, and low hedge ratios are suitable for firms with high credit quality. Additionally, the proposed hedging strategy is useful for companies in the financial industry, particularly for better management of portfolio credit risk.