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Assessing Sovereign CDS Hedge Effectiveness Through P&L Attribution

Article Quant Q&A · Author: tweedi
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Summary

The document explains how to evaluate sovereign credit default swap hedges in a portfolio of sovereign and corporate bonds. It separates jump-to-default exposure from spread sensitivity: sovereign CDS protection may offset sovereign credit spread risk, but it does not directly hedge a corporate bond’s default risk or its spread premium over the sovereign. For spread risk, CDS and bond CS01 can be calculated by tenor bucket, using observed spreads or corporate spread proxies where necessary.

Daily profit-and-loss attribution can break results into CDS spread changes, carry, roll-down, interest rates, bond-CDS basis, and corporate spread exposure. The attribution shows which risks the hedge offsets and which remain. The document proposes evaluating hedge performance across historical market moves or simulated scenarios, then examining total P&L and its components. These measures depend on the quality of market data, proxy spreads, models, and scenario assumptions; sovereign CDS cannot hedge basis risk or corporate-specific spread risk on its own.

Key ideas

  • Separate jump-to-default exposure from credit spread sensitivity when assessing a CDS hedge.
  • Use bond and CDS CS01 by tenor to examine spread risk alignment.
  • Attribute P&L to spread changes, carry, roll-down, rates, basis, and corporate-specific spreads.
  • Test hedge behavior against historical market data or simulated market scenarios.
  • Sovereign CDS does not directly hedge corporate default or corporate spread risk over the sovereign.

Tags

Fixed incomeDerivatives pricingRisk managementBacktesting
Full text
# How to measure effectiveness of CDS hedging


# How to measure effectiveness of CDS hedging












In a fixed income emerging markets portfolio investing in Sovereign and Corporates, CDS on governement bonds are used for hedging credit risk.

To be clear CDS are used to hedge both the exposure of sovereign bonds and corporate bonds.

How can I measure the effectiveness of the CDS hedge? I have all portfolio composition as well as risk analytics (CS01 etc) already calculated by a risk system.

## Answer by Dimitri Vulis (score 1)

https://quant.stackexchange.com/a/47579

There are two kinds of credit risk: jump to default (JTD) and the CDS spread delta (CS01).

If you're long a corporate bond, and you bought CDS protection on the sovereign, and the corporate bond defaults, then you don't have an effective JTD hedge. So let's just focus on CS01 hedge.

Assume for simplicity that all the bonds are USD-denominated and that you have these components:

You can observe the sovereign CDS spread (but perhaps not the corporate CDS spreads) and the bond quotes.

If you can't observe the CDS spreads for some of the corporates, you can proxy, for example as sovereign CDS spread + corporate - soveregn z-spreads.

A CDS model can compute CS01 by tenor bucket.

A bond model can compute the bond-CDS basis (given bond quote and CDS spread) and also CS01 by tenor bucket and interest rate deltas by tenor bucket.

A P&L explain (P&L attribution analysis - PAA) attributes the P&L from CDS to the changes in CDS spreads, carry, rolldown, interest rates (IR - very little for CDS); and the P&L from CDS in terms of all these and also the bond-CDS basis. (You can further reduce unexplained P&L by including CDS spread gamma and various cross-gammas.)

The daily PAA will show how much P&L came from CDS spread movement (you can choose the CDS, and occasionally adjust so little net P&L would be here), interest rate (which you can also hedge if you like), bond-CDS basis (which you cannot hedge with CDS), and the additional credit spread of corporates over sovereign (which you cannot hedge with sovereign CDS, but could hedge with corporate CDS if they trade).

To show the effectiveness, you can backtest (like historical VaR) - show what the P&L would have been over the last few years of historical market data and/or generate many Monte Carlo scenarios (like VaR) for what can happen to your market data; and see what the P&L would have be umder all these market moves, and how much of this P&L is attributable to what.

Shown in full with attribution under the source's licence. Licence: CC BY-SA 4.0 (Stack Exchange)

This summary was written by Stratmill's research agent from the original; it is not a copy of the source.