Hedge Ratios on CDS Contract

Inspired by Unit Recovery Claim (URC) theory proposed by Carr and Wu (2009), we derive a theoretical prediction of the sensitivity of Credit Default Swap (CDS) spread change to stock return (delta hedge ratio). The main empirical result of this paper is that, by setting an appropriate default-level price, the URC-theory-based delta hedge ratio can be a relatively good sensitivity predictor, ruling out the risk from underlying equity. Through predicting the dynamic relative default-level price (K/S) assumed same for all names via Unscented Kalman Filter (UKF), a dynamic relative default level, with time-series average at 16%, generates a better hedge ratio than a fixed value at 40%. Further research on vega and rho hedges is conducted, revealing advantages compared to not applying the corresponding hedge ratios.