Credit Derivatives: Trading, Investing and Risk Management, Second Edition

17

Single Name Book Management

The aim of ‘book’ or ‘portfolio’ management is to understand and control the risks. Risk is related to potential changes in value, and these can be assessed in two different ways.

1. A ‘level/duration/convexity’ approach. We may describe the full functionality of the value function by the values of all the derivatives of that function to all inputs. The first-order derivatives are variously called ‘PV01’, ‘sensitivity’, ‘duration’. Second-order derivatives include ‘convexity’. Book risk can be measured by the values of these derivatives - but typically we only look at derivatives up to second or third order. If a derivative is close to zero, then the book is hedged. On this approach a 1-year and a 20-year trade will both contribute risks to these measures (sensitivity, convexity, etc.) and will add to (or net against) each other. Note that risks beyond second order can be significant (in a 1-, 5-, 30-year CDS deal spread hedged and convexity hedged - ‘twist’ risk would be very large).

2. A ‘bucketing’ approach. We look at sensitivities only (first-order changes only) but only aggregate risks on ‘similar’ trades (e.g. both 5-year BBB-rated US names). Typically a 1-year and a 20-year deal would not lead to an aggregated risk position.

We have already illustrated the bucketing approach in Chapter 10 with the simplified ‘risk charts’. The subject of this chapter is how to control and manage risk in these CDS positions in practice.

17.1 RISK AGGREGATION ...