Hi Richard, I am not sure how guys in banks hedge credit derivatives: it is just difficult, cos the credit market is not liquid. But, theoratically speaking, there is always ways to do so. Let's take a short position in credit default swap for an example, you receive the swap premium and pay the contingent payment in case of default of the reference bond. You can replicate the cash flows by at least two methods:
1. long the FRN with same credit rating as the reference bond, and short AAA FRN;
2. Short AAA bond and buy a credit risky asset swap.
Theoratically, it is OK, but practically, it may not be feasible, cos you may not find the desired FRN due to the depth of the market. By the way, the credit swap premium is highly related to the asset swap spread, so asset swap, which is more liquid, may be a good instrument to look at.
Andrew
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