Scandinavian Working Papers in Economics
Working Papers in Economics,
University of Gothenburg, Department of Economics
No 502: Dynamic Hedging of Portfolio Credit Risk in a Markov Copula Model (Previous title: Dynamic Modeling of Portfolio Credit Risk with Common Shocks)
Tomasz R. Bielecki, Areski Cousin, Stéphane Crépey and Alexander Herbertsson ()
Additional contact information
Tomasz R. Bielecki: Illinois Institute of Technology and Université Lyon 1, Postal: Dept of Applied Mathematics, Chicago, IL 60616, USA, and, Univ. Lyon, LSAF, France
Areski Cousin: Université d'Évry Val d'Essonne, Postal: Laboratoire Analyse et Probabilités, F-91025 Évry Cedex, France
Stéphane Crépey: Université d'Évry Val d'Essonne, Postal: Laboratoire Analyse et Probabilités, F-91025 Évry Cedex, France
Alexander Herbertsson: Department of Economics, School of Business, Economics and Law, Göteborg University, Postal: Centre for Finance, Box 640, SE 405 30 Gothenburg, Sweden
Abstract: We consider a bottom-up Markovian copula model of portfolio credit risk where dependence among credit names mainly stems from the possibility of simultaneous defaults. Due to the Markovian copula nature of the model, calibration of marginals and dependence parameters can be performed separately using a two-steps procedure, much like in a standard static copula set-up. In addition, the model admits a common shocks interpretation, which is a very important feature as, thanks to it, efficient convolution recursion procedures are available for pricing and hedging CDO tranches, conditionally on any given state of the underlying multivariate Markov process. As a result this model allows us to dynamically hedge CDO tranches using single-name CDSs in a theoretically sound and practically convenient way. To illustrate this we calibrate the model against market data on CDO tranches and the underlying single-name CDSs. We then study the loss distributions as well as the min-variance hedging strategies in the calibrated portfolios.
Keywords: Portfolio Credit Risk; Basket Credit Derivatives; Dynamic Min-Variance Hedging; Common Shocks; Markov Copula Model
JEL-codes: G11
45 pages, First version: May 18, 2011. Revised: October 12, 2012.
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