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Hedging default risks of CDOs in Markovian contagion models

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  • J.-P. Laurent
  • A. Cousin
  • J.-D. Fermanian

Abstract

We describe a replicating strategy of CDO tranches based upon dynamic trading of the corresponding credit default swap index. The aggregate loss follows a homogeneous Markov chain associated with contagion effects. Default intensities depend upon the number of defaults and are calibrated onto an input loss surface. Numerical implementation can be carried out thanks to a recombining tree. We examine how input loss distributions drive the credit deltas. We find that the deltas of the equity tranche are lower than those computed in the standard base correlation framework. This is related to the dynamics of dependence between defaults.

Suggested Citation

  • J.-P. Laurent & A. Cousin & J.-D. Fermanian, 2011. "Hedging default risks of CDOs in Markovian contagion models," Quantitative Finance, Taylor & Francis Journals, vol. 11(12), pages 1773-1791.
    • Handle: RePEc:taf:quantf:v:11:y:2011:i:12:p:1773-1791
    DOI: 10.1080/14697680903390126
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    Cited by:

    1. Ascheberg, Marius & Bick, Björn & Kraft, Holger, 2013. "Hedging structured credit products during the credit crisis: A horse race of 10 models," Journal of Banking & Finance, Elsevier, vol. 37(5), pages 1687-1705.
    2. Wen-Qiong Liu & Wen-Li Huang, 2019. "Hedging Of Synthetic Cdo Tranches With Spread And Default Risk Based On A Combined Forecasting Approach," International Journal of Theoretical and Applied Finance (IJTAF), World Scientific Publishing Co. Pte. Ltd., vol. 22(02), pages 1-17, March.
    3. Henri Pages & Dylan Possamaï, 2014. "A mathematical treatment of bank monitoring incentives," Finance and Stochastics, Springer, vol. 18(1), pages 39-73, January.

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