delta-hedging correlation risk.pdf

Delta-hedging Correlation Risk? Areski Cousin1∗ (areski.cousin@univ-lyon1.fr) Stéphane Crépey2† (stephane.crepey@univ-evry.fr) Yu Hang Kan3,† (gabriel.kan@) 1 Université de Lyon, Université Lyon 1, LSAF, France 2 Laboratoire Analyse et Probabilités, Université d’Évry Val d’Essonne, 91025 Évry Cedex, France 3 IEOR Department Columbia University, New York June 6, 2011 Abstract While the Gaussian copula model is commonly used as a static quotation device for CDO tranches, its use for hedging is questionable. In particular, the spread delta computed from the Gaussian copula model assumes constant base correlations, whereas we show that the correlations are dynamic and correlated to the index spread. It might therefore be expected that a dynamic model of credit risk, which is able to capture the dependence between the base correlations and the index spread, will have better hedging performances. In this paper, we compare delta hedging of spread risk based on the Gaussian copula model, to the implementation of jump-to-default ratio computed from the dynamic local intensity model. Theoretical and empirical analysis are illustrated by using the market data in both before and after the subprime crisis. We observe that delta hedging of spread risk outperforms the implementation of jump-to-default ratio in the pre-crisis period associated with CDX.NA.IG series 5, and the two strategies have comparable performance for crisis period associated with