| Abstract: |
We compare the performance of various hedging strategies for index CDO
tranches across a variety of models and hedging methods during the recent
credit crisis. Our empirical analysis shows evidence for market
incompleteness: a large proportion of the risk in CDO tranches appears to be
unhedgeable. We also show that, unlike what is commonly assumed, dynamic
models do not necessarily perform better the static models, nor do
high-dimensional bottom-up models perform better than simpler top-down models.
Moreover, top-down and regression-based hedging would have provided
significantly better hedges than bottom-up hedging with single name CDS during
the Lehman Brothers default event. Our empirical study also reveals that while
significantly large moves -” jumps” -do occur in the CDS, index and tranche
spreads, these jumps do not necessarily occur on default dates of index
constituents, an observation which contradicts the intuition conveyed by some
recently proposed credit risk models. |