Hedging the Credit Risk Premium

Terry Benzschawel

This article was first published as a chapter in Credit Modelling (2nd edition), by Risk Books.

OVERVIEW

In this chapter, we will use our understanding of the credit risk premium (see Chapter 5) to devise and test methods for hedging systematic spread moves in cash bonds due to changes in investors risk appetites and/or market volatility. Based on the ability to decompose credit spreads into default and non-default components, short positions in the North American investment-grade CDS index, CDX. IG.NA, provide very good hedges for changes in the credit spread premiums of cash bonds. In particular, we find that changes in CDX. IG.NA best track changes in bonds’ risk premiums over three-month periods. Thus, we use trailing three-month changes as the basis for computing hedge ratios, β_t, between the cash bond risk premium and the CDS index. We report a comparison of performance of a naïve hedging strategy (ie, β_t = 1) with a dynamic strategy whereby the hedge ratio is determined based on the slopes of regression analyses on a rolling window of changes in the CDS index and the credit risk premium. The naïve β_t = 1 hedge performs well except during the liquidity crisis of late 2007