We discuss dynamic hedging of counterparty risk for a portfolio of credit derivatives by the local risk-minimization approach. We study the problem from the perspective of an investor who, trading with credit default swaps (CDS) referencing the counterparty, wants to protect herself/himself against the loss incurred at the default of the counterparty. We propose a credit risk intensity-based model consisting of interacting default intensities by taking into account direct contagion effects. The portfolio of defaultable claims is of generic type, including CDS portfolios, risky bond portfolios and first-to-default claims with payments allowed to depend on the default state of the reference firms and counterparty. Using the martingale representation of the conditional expectation of the counterparty risk price payment stream under the minimal martingale measure, we recover a closed-form representation for the locally risk minimizing strategy in terms of classical solutions to nonlinear recursive systems of Cauchy problems. We also discuss applications of our framework to the most prominent classes of credit derivatives. © 2019, Springer Science+Business Media, LLC, part of Springer Nature.

Locally Risk-Minimizing Hedging of Counterparty Risk for Portfolio of Credit Derivatives / Bo, Lijun; Ceci, Claudia. - In: APPLIED MATHEMATICS AND OPTIMIZATION. - ISSN 0095-4616. - 82:2(2020), pp. 799-850. [10.1007/s00245-018-9549-y]

Locally Risk-Minimizing Hedging of Counterparty Risk for Portfolio of Credit Derivatives

Ceci Claudia
2020

Abstract

We discuss dynamic hedging of counterparty risk for a portfolio of credit derivatives by the local risk-minimization approach. We study the problem from the perspective of an investor who, trading with credit default swaps (CDS) referencing the counterparty, wants to protect herself/himself against the loss incurred at the default of the counterparty. We propose a credit risk intensity-based model consisting of interacting default intensities by taking into account direct contagion effects. The portfolio of defaultable claims is of generic type, including CDS portfolios, risky bond portfolios and first-to-default claims with payments allowed to depend on the default state of the reference firms and counterparty. Using the martingale representation of the conditional expectation of the counterparty risk price payment stream under the minimal martingale measure, we recover a closed-form representation for the locally risk minimizing strategy in terms of classical solutions to nonlinear recursive systems of Cauchy problems. We also discuss applications of our framework to the most prominent classes of credit derivatives. © 2019, Springer Science+Business Media, LLC, part of Springer Nature.
2020
Local risk-minimization; Counterparty risk; Recursive system of Cauchy problems
01 Pubblicazione su rivista::01a Articolo in rivista
Locally Risk-Minimizing Hedging of Counterparty Risk for Portfolio of Credit Derivatives / Bo, Lijun; Ceci, Claudia. - In: APPLIED MATHEMATICS AND OPTIMIZATION. - ISSN 0095-4616. - 82:2(2020), pp. 799-850. [10.1007/s00245-018-9549-y]
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Utilizza questo identificativo per citare o creare un link a questo documento: https://hdl.handle.net/11573/1660601
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