Market risk when hedging a global credit portfolio

• Alvaro Chamizo ^[2] ; Alfonso Novales ^[1]
  1. [1] Universidad Complutense de Madrid

     Universidad Complutense de Madrid

     Madrid, España

     
  2. [2] BBVA
• Localización: Documentos de Trabajo (ICAE), ISSN-e 2341-2356, Nº. 28, 2019, págs. 1-37
• Idioma: inglés
• Enlaces
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• Resumen

  • Hedging a credit portfolio using single nameCDS is affected by high spread volatility that induces continuous changes in a portfolio mark to market, which is a nuisance. Often, the problem is that CDS on firmsin the portfolio are not being traded. Toget around that, a derivative portfolio can be hedgedbytakinga contrarypositionina creditindex, andweexamine inthispaperthe efficiencyof such an imperfect hedge. Wefind overthe 2007-2012 period an 80% hedging efficiency for a European portfolio, 60% for North American and Japanese portfolios, and around 70% for a global portfolio, as measured bythe reduction inmark-to-market variance. We also considersectorial credit portfolios forEuropeandNorthAmerica,forwhichhedgingefficiencyisnotashigh,duetotheirmore 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. Standard conditional volatility models provide similar results to the least squares hedge, except forextrememarketmovements.Anefficienthedgeforacreditportfoliomadeupofthemostidiosyncraticfirmswould seemto requiremore than 50 firms,while the hedge for portfoliosmade up ofthe lessidiosyncratic firms achieves high efficiency even for a small number offirms. The efficiency ofthe hedge is higher when portfolio volatility is high and alsowhen short terminterestrates or exchange ratevolatilityarehigh. IncreasesinVIX,inthe 10-yearswap rateorinliquidityrisktend to decrease hedging efficiency. Creditindices offer amoderatelyefficient hedge for corporate bond portfolios, which we have examined with a reduced sample offirms over 2006-2018. This analysis also showsthat the current efficiencyof a creditindexhedgehasrecoveredatpre-crisislevels.