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Evaluation of market risk associated with hedging a credit derivative portfolio

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  • Chamizo, Álvaro
  • Novales, Alfonso

Abstract

Hedging a credit portfolio using single-name credit default swap (CDS) is affected by low liquidity and high spread volatility, which induces continuous changes in a portfolio mark-to-market. As an alternative, we consider hedging a derivative portfolio by taking a contrary position in a credit index, evaluating the empirical market risk that remains after such hedge. We perform three different hedging exercises: for single-names, for sectorial portfolios and for regional portfolios. We implement least squares hedging as a benchmark, and compare its efficiency with a hedge ratio estimated under the RiskMetrics exponentially moving average (EWMA) specification for time varying second order moments, as well as with the hedge ratio obtained from a bivariate GARCH model for the portfolio and the credit index used as a hedge. Over the 2007–2012 period, we find a high hedging efficiency for regional portfolios (Europe, North America and Japan), as well as for a global portfolio, which is back at pre-crisis levels. The EWMA hedge is slightly more efficient than the least-squares hedge, while the GARCH hedge does not improve hedging efficiency. Hedging efficiency is not as high for sectorial credit portfolios from Europe and North America, due to their more important idiosyncratic component. Taking 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. This hedging strategy becomes much more complex if firms in the portfolio have a large idiosyncratic component. The efficiency of the hedge is higher when liquidity risk and systematic risk are high, or when the term structure is flat. We also provide evidence suggesting that credit indices can also offer a moderately efficient hedge for corporate bond portfolios, which we have examined with a reduced sample of firms over 2006–2018.

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  • Chamizo, Álvaro & Novales, Alfonso, 2021. "Evaluation of market risk associated with hedging a credit derivative portfolio," The Quarterly Review of Economics and Finance, Elsevier, vol. 80(C), pages 411-430.
    • Handle: RePEc:eee:quaeco:v:80:y:2021:i:c:p:411-430
    DOI: 10.1016/j.qref.2021.03.006
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    More about this item

    Keywords

    Market risk; CDS; Credit indices; Credit hedge; Asset allocation; Systemic risk;
    All these keywords.

    JEL classification:

    • G01 - Financial Economics - - General - - - Financial Crises
    • G12 - Financial Economics - - General Financial Markets - - - Asset Pricing; Trading Volume; Bond Interest Rates
    • G13 - Financial Economics - - General Financial Markets - - - Contingent Pricing; Futures Pricing
    • G14 - Financial Economics - - General Financial Markets - - - Information and Market Efficiency; Event Studies; Insider Trading
    • G15 - Financial Economics - - General Financial Markets - - - International Financial Markets

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