Testing Hedges under the Standard Tranched Credit Model

Abstract

We examine the performance of the standard tranched credit derivative (or synthetic CDO) pricing model over most of the lifetime of these derivatives. As the market for these derivatives is quite liquid, we focus on the application of the model for hedging, rather than for absolute pricing. We investigate first whether the standard model provides demonstrably better hedges than a simple linear regression, and second whether any of the typical variations on the standard model outperforms the others. Our findings demonstrate that the standard model does produce better hedges than a simple benchmark, but that within the numerous variations of the standard model, the simplest one is clearly the most consistent and reliable.

JEL Classification: C52, D40, G12, G13