• Credit Derivatives

    Hedging callable bonds with CDS

    The cash flows of a callable bond depend on the issuer’s decisions in the future, hence are unknown today. Consequently, hedging the default risk of such a bond with a maturity-matched credit default swap (CDS) bears the risk that the CDS becomes orphaned after an early call and needs to be closed with a significant loss. A practical solution might be to split the CDS hedge into several maturity buckets, covering the range of potential call dates. We describe in simple terms how the allocation of the CDS hedge into different maturity buckets can be achieved, based on the computation of market-implied probabilities that the issuer exercises his or her call rights.