Implementing and testing possible hedging strategies to minimise value fluctuations in a defaulted portfolio

Sammanfattning: A Central Counterparty (CCP) handles clearing between its members and can mutualise and reduce the counterparty and credit risk in a network. In the case of a clearing member defaulting on its obligations, the defaulted portfolio will be taken over by the CCP, which will attempt to close out the positions as quickly as possible. It is vital that the CCP minimises the losses they may suffer during the period between default and close out, the so called holding period. This thesis investigates and tests several potential hedging strategies to minimise value fluctuations during the holding period. These include neutralising the exposure to different risk factors, as well as finding the ideal hedging position using principal component analysis. The defaulted portfolio can contain different instruments, such as options, interest rate swaps and bonds, which requires different approaches to neutralise exposure. To determine the performance of the different strategies, backtesting was performed on historical data from the years 2001 to 2013, and the results were analysed in order to determine the effectiveness and potential costs of the hedging. The results show that significant reduction in value fluctuations can be achieved by employing these strategies, while not exceeding an affordable level of cost. Based on the findings, a function was created in Java that can recommend optimal hedging positions given a defaulted portfolio of any composition.