The static hedging of CDO tranche correlation risk

This article gives examples illustrating the static hedging of CDO correlation risk. Changes in correlation result in changes in the relative portioning out of the total expected loss of a reference portfolio to the different tranches. Thus, portfolios with low correlation risk contains a number of CDO tranches whose weights are adjusted so that the daily changes in the mark-tomarket values of the different tranches tends to cancel out. The examples are backtested using iTraxx CDO market spreads for the challenging period following the May 5, 2005 downgrade of General Motors by Standard and Poor’s. The implementation is carried out by using the static loss-surface model of Walker (2005, 2006) and Torresetti, Brigo and Pallavicini (2006). JEL classification code: G13 keywords: CDO’s, hedging Department of Physics, University of Toronto, Toronto, ON M5S 1A7, CANADA; email: [email protected]; telephone: (416) 978-3821. I thank Julien Houdain and Fortis Investments for providing the market quotes used in the examples. The support of the Natural Sciences and Engineering Research Council of Canada is acknowledged.