Cross-Market Hedging Strategies for Credit Default Swaps Under a Markov Regime-Switching Framework

This paper aims to explore strategies used for hedging credit default swap (CDS) risks. By analyzing the AIG financial crisis in 2008, we understand the nature of CDS and why AIG incurred huge losses. In addition, we investigate other financial products that can be used to hedge CDS risks. Complementary to Jarrow (2010) who suggested that government regulation should impose stricter collateral requirements and higher equity capital for CDS traders to minimized CDS seller failure, we provide feasible hedging strategies for CDS sellers instead. Therefore, we contribute to the literature in the following aspects. First, we find that stock returns significantly affect CDS returns depending on regimes and our model is able to capture these switching characteristics. Second, we explain how the correlation between CDS and stock returns can be used to adjust hedge ratios based on different regime switching situation. Finally, we find that high hedge ratios are suitable for firms with low credit quality and low hedge ratios are suitable for firms with high credit quality. Additionally, our proposed hedging strategy is especially useful for companies in the financial industry. Therefore, it is helpful for better management of portfolio credit risk