HEDGING OF SYNTHETIC CDO TRANCHES WITH SPREAD AND DEFAULT RISK BASED ON A COMBINED FORECASTING APPROACH

Abstract

Hedging of credit derivatives, especially the Collateralized Debt Obligations (CDOs), is the prerequisite of risk management in financial market. Since both spread risk and default risk exist, the models in existing literature resort to the incomplete-market theory to derive the hedging strategies. From another point of view, the construction of hedging strategies of CDO might be regarded as the process of forecasting the changes in value of CDO by the changes in value of hedging instruments. Based on this idea, this paper proposes an alternative hedging approach via the combined forecasting and regression techniques, where the two individual forecasting models are Gaussian copula model and local intensity model, used to hedge against spread risk and default risk, respectively. Finally, the dynamic hedge ratios of CDO tranches with CDS index are derived. A numerical analysis is carried out and the hedge ratios obtained by the new models are compared with those from actual market spreads. It is shown that the model derived in this paper not only provides hedging strategies which agree with the market hedge ratios but that can be effectively implemented as well.