Hedging tranches of collateralized debt obligations

Collateralized debt obligations (CDO) are a recent development in credit derivatives market. Credit risk of the collaterals is securitized through issuing tranches. The values of those tranches depend on the default risk characteristics of the pool of collaterals. In this paper, a reduced form model of default is considered. The hazard rates of collaterals follow square-root diffusion processes that can be correlated. The question of hedging the values of tranches against default risk and uncertain movements of hazard rates is analyzed and a feasible hedging strategy using credit default swaps is suggested. The model avoids the static nature of copula models. Sensitivity of results to various parameters of the model is examined.