Is the CreditGrades Model Useful for Hedging CDSs?

The CreditGrades model establishes a direct link between the firm equity and credit risk. We test whether this model can be used to hedge single-name credit default swaps (CDSs). While considering a stochastic volatility process for the reference entity assets, we also study the impact of credit ratings. We show that the model correctly evaluates spread variations, even during the financial crisis of 2008. The correlation between market and model-derived spreads increases when the credit rating of the entity decreases. Our model performs well for the low credit rating entity we study. The fact that spreads obtained using the model do not always match those of the market does not necessarily mean the model fails to evaluate the hedge ratio for the CDS contracts. We believe that the inclusion of components related to market conditions, such as the liquidity of CDS contracts, should improve our CreditGrades model predictive power.