Hi,I would like to know whether a CDS is suitable to hedge the (dynamic) credit exposure on an interest rate swap. Which exposure (e.g. expected, worst-case) needs to be taken? The idea is to incorporate the CDS costs into the IRS quote, meaning that these costs need to be known in advance. I guess hedging worst-case exposure is way too expensive, whereas hedging expected exposure could potentially result in a huge loss. Arvanitis and Gregory (Credit: The ultimate guide to pricing, hedging and risk management, 2001) mention to rebalance the notional of the hedge, because the exposure of an IRS is dynamic. However, I would think that the hedging costs are not known beforehand, so I can’t incorporate the hedging costs into the IRS quote. Furthermore is it also necessary to use CDS’s with various maturities (time buckets)?In the above mentioned I assumed that it is related to a counterparty that can be traded in the CDS market. But let’s assume that it would be a counterparty with no credit rating and no bonds at all. Would it still be feasible to buy protection in the CDS market, or would the premium be sky high? I have the feeling that using CDS’s to hedge credit exposure on an IRS on a stand-alone basis is not very common in the market, except on names that are often traded in the CDS market. However, I have the feeling that the CDS is often used for these purposes on a portfolio level. Who can comment on this?Thanks in advance,Kim

Your analysis is accurate, although people try all sorts of things. Two important issues with dynamic hedging is the cost may be comparable to the loss in an unhedged default, and it's very dangerous to assume continued liquidity in a name, especially as it gets into trouble.