Pricing and trading credit default swaps in a hazard process model (Q2378639)

The risk of credit derivatives is often split into three components: the default risk, the spread risk and the correlation risk. The goal of the paper is to find a mathematically rigorous way to of dealing simultaneously with all three kinds of credit risks. The main results show that in a generic hazard process model driven by a Brownian motion it is, in principle, possible to perfectly hedge all sorts of risks in a unified manner, provided that a large enough number of liquid credit default swaps (CDSs) is traded. The main steps are the following ones: first, the risk-neutral dynamics for the prices of defaultable claims is derived and it is shown that the risk-neutral pricing of defaultable claims can be supported via replication of these claims by dynamic trading of a suitable family of single-name CDSs. Then the authors address the issue of valuation and hedging of defaultable claims in the market with traded CDSs with different maturiries but with the same reference credit name and consider also the case of several correlated credit names. The results are applied to some basket claims.