Understanding and Hedging Risks in Synthetic CDO Tranches

by Matthias Neugebauer of Fitch Ratings,
et. al.

August 4, 2006

Summary: A synthetic CDO tranche is subject to mark-to-market movements as underlying risk drivers move over the life of the transaction. For example, an increase in the credit spread of an underlying credit causes a loss in the value of a long equity tranche position because it implies that the risk of the portfolio has increased and therefore the expected loss of the portfolio has increased. A key element in hedging against unfavourable movements in CDO values is the proper understanding of the sensitivities to risk factor shifts such as changes in:

• credit spreads of the underlying credit default swap ("CDS") contracts;
• credit quality of the underlying CDS contracts;
• default correlation between the underlying CDS contracts; and
• time to maturity

This article details how to measure these sensitivities and shows how this information can be used for risk management purposes. For example, an investor wanting to know their exposure to General Motors would use DV01 ("Dollar Value of a Basis Point") and Value on Default to assess the likely impact of spread widening on GM CDSs and a default, respectively. An investor more worried about systemic risk, which could be seen through a general widening of credit spreads, would use S.DV01 ("Systematic DV01") to see the sensitivity of their instrument.

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