The Static Hedging of CDO Tranche Correlation Risk

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The Static Hedging of CDO Tranche Correlation Risk

by Michael B. Walker of the University of Toronto

February 5, 2008

Abstract: This article gives examples illustrating the static hedging of CDO correlation risk. Changes in correlation result in changes in the relative portioning out of the total expected loss of a reference portfolio to the different tranches. Thus, portfolios with low correlation risk contains a number of CDO tranches whose weights are adjusted so that the daily changes in the mark-to-market values of the different tranches tends to cancel out. The examples are backtested using iTraxx CDO market spreads for the challenging period following the May 5, 2005 downgrade of General Motors by Standard and Poor's. The implementation is carried out by using the static loss-surface model of Walker (2005, 2006) and Torresetti, Brigo and Pallavicini (2006).

JEL Classification: G13.

Keywords: CDO's, hedging.

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