Default neutral hedge ratio

For example, let us assume that an investor holds a bond with a price, Pbond that the recovery on this bond in the event of default is bond- The loss to the investor is (Pbond bond) result of the default. Flowever, the investor can hedge the bond position by buying CDS protection, for an amount equal to the default neutral hedge ratio multiplied by the standard CDS contract. 

The payoff from the standard CDS contract is (1 - PcDs) nd the default neutral hedge ratio multiplied by (1 - Rqds) would provide the hedging cash flow to offset the loss on the bond position. 

For bond positions hedged via CDSs in a default neutral hedge ratio, the profit and loss generated will depend on the recovery values actually obtained for the bond and the CDS contract. The assumptions regarding recovery are crucial for hedge effectiveness. 

The notional value of the CDS protection is equal to the market price of the bond. This is effectively the same as the default neutral hedge ratio with the recovery equal to zero. 

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