Created by Dr. Jan-Frederik Mai

Jointly hedging jump-to-default risk and mark-to-market risk

When entering a position that is long credit, two major sources of risk are present. On the one hand, there is the fundamental jump-to-default (JTD) risk, which is most important from a hold-to-maturity perspective. On the other hand, there is mark-to market (MTM) risk due to daily fluctuations in the credit spreads. When hedging such a long credit position by a short equity position, both risk constituents have an effect on the hedge ratio and need to be balanced. The overall position should be JTD-neutral, meaning that default risk is hedged perfectly, and MTM-neutral, meaning that MTM risk is hedged perfectly. When hedging with a long put position, the choice of the strike price provides enough freedom to make the overall position both JTD- and MTM-neutral, which in general is not possible with a pure (linear) forward hedge.


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