Hedging portfolios of financial guarantees

Abstract

We propose a framework a la Davis et al. (1993) and Whalley and Wilmott (1997) to study dynamic hedging strategies on portfolios of financial guarantees in the presence of transaction costs. We contrast four dynamic hedging strategies including a utility-based dynamic hedging strategy, in conjunction with using an asset-based index, with the strategy of no hedging. For the proposed utility-based strategy, the portfolio rebalancing is triggered by the tradeoff between transaction costs and utility gains. Overall, using a Froot and Stein (1998) and Perold (2005) type of risk-adjusted performance measurement metric, we find the utility-based strategy to be a good compromise between the delta hedging strategy and the passive stance of doing nothing. This results is even stronger with higher transaction costs. However, if the insured firms assets are not traded, the guarantor can use an index-based security as hedging instrument, especially in a high transaction costs environment.

Synthetizing a debt guarantee: Super-replication versus utility approach

“…Huynh, Lai, and Soumaré (2008) are our reference for what follows. The reader may refer to it for further details.…”

“…The guarantor's return depends on the value of the replicated guarantee at maturity, the payment in the event of default, and the premium. Following Wirch and Hardy (1999) and Lai, Langlois, and Soumaré (2008), we will assume that the premium charged to the client is:…”