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Conference of 2007
Finance Center Münster
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Credit derivatives are subject to at least two sources of risk: the default time and the recovery payment. This paper examines the impact of modeling the recovery payment on hedging strategies in a reduced-form model as well as a Merton-type model. We show that quadratic hedging approaches do only depend on the emph{expected} recovery payment at default and not the whole shape of the recovery payment distribution. This justifies assuming a _certain_ recovery payment conditional on the default time. Hence, this result allows a simplified modeling of credit risk.
Abstract
Robust Recovery Risk Hedging: Only the First Moment Matters
Trautmann, Siegfried; Müller, MonikaCredit derivatives are subject to at least two sources of risk: the default time and the recovery payment. This paper examines the impact of modeling the recovery payment on hedging strategies in a reduced-form model as well as a Merton-type model. We show that quadratic hedging approaches do only depend on the emph{expected} recovery payment at default and not the whole shape of the recovery payment distribution. This justifies assuming a _certain_ recovery payment conditional on the default time. Hence, this result allows a simplified modeling of credit risk.