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This article was authored by Stephen Loosley, Catalyst Development Ltd, a financial regulations and technology advisor in London.
Compression is a technique to reduce gross notional in your OTC book without materially affecting risk, allowing you to use fewer trades and less notional to express the same risk, at less cost.
The term is commonly used to mean three different, but related things: netting, blended coupon netting, and risk constrained compression.
• Netting is the process of eliminating trades of exactly opposite economics. A five year fixed pay for $300m@3.2% against 3M LIBOR vs. a five year fixed receive for $300m@3.2% against 3M LIBOR will net to zero. If the fixed pay is $310m, these two swaps net to a fixed pay swap of $10m, with zero risk and P&L impact.
• Blended coupon netting is the same as netting, with one crucial difference: it offsets trades with varying coupons on the fixed leg. These can net down with no economic impact, with the addition of a replacement trade representing the coupon weighted notional of the averaging process.
• Risk constrained compression ("true compression") is still close to risk neutral. Firms offset against a risk profile subject to tolerances on analytics such as a DV01 ladder, rather than against exact trade parameters. Risk and the front office together decide how narrow tolerances should be, based on the purpose of the underlying trades. For...................... To view our full article Click here
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