HEDGING OF DEFAULT RISK: A REPLICATION-BASED APPROACH

Marek Rutkowski
(joint work with Tomasz R. Bielecki and Monique Jeanblanc)

Abstract

We deal with the valuation and hedging of attainable defaultable claims in the situation when there are liquid instruments available for trading that have risk exposures to the same risk factors as derivative assets. In contrast to some other related works (see, for instance, Belanger et al. (2001) or Blanchet-Scalliet and Jeanblanc (2000)), we directly analyse the possibility of replication of a given defaultable contingent claim by means of a trading strategy based on default-free and defaultable securities. This approach, motivated by the working paper by Vaillant (2001), leads directly to explicit expressions for replicating strategies. General results are subsequently applied to standard cases of credit derivatives.