Neutralising DV01 can shelter you from the storm – but if you don’t also manage curve risk and carry, you’re standing under a leaky roof.

From my recent articles you may have picked-up on some basics of DV01, swap pricing and derivatives PnL. It would be easy to conclude that interest rate trading is about managing exposure to “the” interest rate – with curves, carry, and discounting little more than mathematical projections layered on top.

That’s not how a swaps book actually works.

Neutralising DV01 risk can help traders shelter from a storm. But if you don’t also manage curve risk, carry and discount risk then you’ll have a leaky roof.

Managing risk in a DV01 world

The reality of managing an interest rate book is that the portfolio is exposed to over 18,000 daily discount factors (all the way out to 50 years). No trader is able – or expected – to hedge that many distinct risks.

In this context, DV01 is a dimensionality reduction tool. It is used to make these risks manageable, but it is therefore NOT a complete description of a trading book.

We get to see this played-out in real-time as year-end approaches.

The dual roles of a swaps trader

The job has two aspects:

Risk Management

• Maintaining, understanding and explaining exposures to all drivers of portfolio valuations.
• Keeping all exposures within well-defined risk limits.
• Running appropriate levels of risk relative to annual PnL targets.

Liquidity Transformation

• Enabling client trades.
• Warehousing mismatched risks.
• Taking liquidity in highly commoditised products such as futures and cash bonds and transforming it into customised client-focused products.

Spread trading and basis trading – asset swaps, spreadovers, invoice spreads and even cross currency swaps – are all examples of transferring sources of liquidity (or funding in the case of XCCY) from one place to another.

Sadly, these two functions are rarely symbiotic. I can count on one hand the times I remember being able to minimise my risks thanks to transforming liquidity for clients!

Frequently, such as at year-end, one role dominates the other.

And at year-end, a traders appetite for liquidity transformation dries up. It is all about risk management.

Why This Impacts Clients

When swap traders reduce their activity in liquidity transformation products, clients will see:

• Wider bid-offer spreads
• A harder time getting a quote
• Limited appetite for DV01 neutral packages such as curve risk
• Zero appetite to take the other side of negative carry trades

This all seems very counterintuitive when written down like this. Markets don’t stop moving. Portfolio valuations are still exposed to the vagaries of 18,000 calculations moving around. Those “great entry levels” for the go-to trades still look as attractive as ever on the charts.

But what really motivates traders at the end of the year? Positioning for next year.

Pre-Positioning

What replaces liquidity transformation at year-end is not inactivity – it is pre-positioning. And unless you’ve sat on a swaps (or options) desk, the following is going to sound like a mixture of magic and insanity:

The best trade at the end of the year is one that “pushes” PnL into the next year.

To be clear, I am not talking about system or valuation arbitrage here! Traders are not naive enough to trade mis-marked products – it is a fools game.

Rather, managing a swaps portfolio at this time of year involves:

• Putting on new positive carry positions. It is worth paying away bid-offer this year to start the next year with positive carry.
• Stub management. If we are in a rate hiking cycle, make sure that your stub is mainly DV01 positive until the March IMM (and vice versa). It is again worth paying away bid-offer at the end of the year to achieve this.
• Balance sheet management. The last conversation you want to start the year with in January is “why didn’t you compress to reduce your leverage balance sheet footprint”.
• January starts with a big issuance bang, compressing swap spreads. Selling spreads is a common tactic over the year-end.

The Perfect Trade

Want to give the swaps trader close to you the perfect Christmas gift? Ask them for their offer in 5y5y just before they leave for Christmas.

Why?

• 5y5y rolls down a steep part of the forward curve, decaying to a 5y4y, generating positive carry (see blog here).
• The swaps trader can sell bond futures against the outright DV01, generating a short swap spread position. As issuance ramps up in January, issuers receiving fixed in swaps compress swap spreads. This hedge pre-positions for that.

On the curve, the “hedged” position looks messy:

Showing;

• Mis-matched bucket risk all over the place!
• This is because the Cheapest to Deliver bond, even the “Ultra” 10Y, doesn’t match with swaps dates.
• But most swaps traders would agree that running this position over year-end is far less risky than either a) running the opposite risk (i.e. it is an asymmetric trade) or b) bothering to hedge it!

Which brings us nicely onto DV01 neutrality.

DV01 neutrality is a misleading myth

It is hence a myth that traders do not run risk over Christmas and New Year. Having a net DV01 exposure across the Rates curve of “zero” is not a risk free strategy.

• DV01 neutrality is far from benign – PnL will still be non-zero even with no “net” risk.
• A defensive book makes sense – minimise PnL volatility by all means into year end. But better to set up well for next year.
• This plays out in markets by way of poor liquidity. Everyone wants to do the same thing, whether they’ve had a good year or a bad year.
• It highlights why swaps traders cannot only be risk managers.

This can also play straight into client’s hands. I remember quoting on fwd-fwds, wanting to receive the curve and sell futures against it (positive carry and short spreads. Whoop!). Quoting at “mid” didn’t even get a look in – I think the hedge fund traded a whole basis point through!

In Summary

DV01 neutrality is not the safe resting state that swaps books aim for at year-end. Markets still move and risk still exists. Opportunities remain – but exploiting them looks different to the rest of the year. Liquidity transformation and client intermediation give way to risk management and pre-positioning.

That’s why year-end trading feels different. Not because traders stop caring about markets – but because liquidity transformation has switched off, and risk management has taken over.