Dynamic Hedging of Synthetic CDO Tranches with Spread Risk and Default Contagion

by Rüdiger Frey of the Universität Leipzig, and
Jochen Backhaus of the Universität Leipzig

October 6, 2009

Abstract: The paper is concerned with the hedging of credit derivatives, in particular synthetic CDO tranches, in a dynamic portfolio credit risk model with spread risk and default contagion. The model is constructed and studied via Markov-chain techniques. We discuss the immunization of a CDO tranche against spread- and event risk in the Markov-chain model and compare the results with market-standard hedge ratios obtained in a Gauss copula model. In the main part of the paper we derive model-based dynamic hedging strategies and study their properties in numerical experiments.

JEL Classification: G13, G33, D52.

Keywords: Dynamic hedging, portfolio credit risk, credit derivatives, incomplete markets, default contagion.

Published in: Journal of Economic Dynamics and Control, Vol. 34, No. 4, (April 2010), pp. 710-724.

Previously titled: Dynamic Hedging of Synthetic CDO Tranches with Spread- and Contagion Risk

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