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

24

Correlation Portfolio Management

The ‘correlation book’ contains risks arising from portfolio products including N2D baskets, CDO tranches, and portfolio volatility products.

24.1 STATIC AND DYNAMIC HEDGES

Statically (Default Event) Hedged Book

CDO deals may be default event hedged on a static basis, as described in Chapter 23. We saw that a statically hedged deal is not risk free - there is residual delta risk which will give rise to mark-to-market P&L changes. This residual may be minimised through product design, otherwise it can reach high values (equivalent to a naked spread position in 50% of the reference pool notional on a long-life high-yield portfolio).

If the ‘static hedge’ is incorporated with other deals in the correlation product book then the residual risk will be automatically and actively delta hedged. For this reason statically hedged deals need to be segregated from the rest of the correlation book to avoid the unwanted P&L arising from rehedging. The owner of the position remains exposed to the spread risk.

 

 

Dynamic Delta Hedged Book

We examine the delta hedging of several types of trades, and the consequences of this approach.

Example 1 Long F2D Protection, Long Equity Protection A position long of protection in a F2D basket is delta hedged by selling single name protection on the individual names in the basket - say around 50-60% notional for each name in the basket, depending on the correlation and depending on spread. This brings a strong (short) ...