Some short elements on hedging credit derivatives

Natixis, 115 rue Montmartre, F-75002 Paris, France; philippe.durand@polytechnique.org; jean-frederic.jouanin@ponts.org

Accepted: September 2005

Abstract

In practice, it is well known that hedging a derivative instrument can never be perfect. In the case of credit derivatives (e.g. synthetic CDO tranche products), a trader will have to face some specific difficulties. The first one is the inconsistence between most of the existing pricing models, where the risk is the occurrence of defaults, and the real hedging strategy, where the trader will protect his portfolio against small CDS spread movements. The second one, which is the main subject of this paper, is the consequence of a wrong estimation of some parameters specific to credit derivatives such as recovery rates or correlation coefficients. We find here an approximation of the distribution under the historical probability of the final Profit & Loss of a portfolio hedged with wrong estimations of these parameters. In particular, it will depend on a ratio between the square root of the historical default probability and the risk-neutral default probability. This result is quite general and not specific to a given pricing model.