Hedge Effectiveness of the Credit Default Swap Indices: a Spectral Decomposition and Network Topology Analysis

The hedge effectiveness of the credit default swap (CDS) indices is analyzed. Starting with the CDS eligible for inclusion in the indices, CDX.NA.IG, CDX.NA.HY, iTraxx Europe and iTraxx Xover, a credit portfolio construction algorithm is proposed. It is based on principal components for variable selection. The spectral decomposition defines a deletion criterion that selects alternative portfolios of CDS for comparison to the printed indices. Hedge back testing indicates that as few as 2 names can replicate the behavior of the traded index with volatility reductions of up to an order of magnitude. To understand this, the network topology of the CDS is then studied via hierarchical trees and an associated nested factor model. This shows a 'market effect' across the majority of CDS eligible for a specific index, which equates to low information content versus the broader market. The net result is that a small subset of credits captures the price action.