Please tell me the difference between CS01 and RST 1% (Relative spreads tightening by 1%) and how these two are used to monitor the credit flow traded product's exposures. Why would you use the spread tightening to monitor the risk?
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There is no standard nomenclature, but:
Often "CS01" means the P&L impact of credit spreads changing by 1 bp - the credit spread delta. It's often used as a risk measure by credit trades. Some people prefer to look at spread tightening, others at widening, it does not matter as long as you remember which one you use. CS01 is convenient because if a paricular spread changes by some number of basis points, and you multiple the change by CS01, you immediately get a first-order estimate of the resulting P&L. If you also add in the credit gamma, you can have good P&L explain. The disadvantages of CS01 include:
it ignores the convexity (credit spread gamma), which can be quite material if the credit spread moves by tens of basis points.
if the book has both investment grade (e.g. 30 bps spread) and high yield (e.g. 700 bps spread), then aggregating their CR01s is like comparing apples and oranges. It's almost like having a penny stock and BRK and asking what happens if all stock prices change by 1 dollar.
this seldom happens, but if the spread is very tight, then perturbing one tenor by 1 bp may result in a curve that admits arbitrage (has some negative hazard rates).
if you use this methodology for stress testing - i.e. don't ignore convexity, but ask what happens if all spreads widen, e.g., 100bps, then you may end up with a curve shape that admits arbitrage; or a shape that doesn't admit arbitrage, but still does not look like something that would arise in the market.
A relative, rather than absolute bump, works better for credit stress testing. Risk scenarios where every credit spread widens, e.g., 1%, 10%, 50%, i.e. a 100 bps spread becomes 101, 110, 150 bps, whereas a 200 bps spread becomes 202, 220, 300 bps, more realistically describe what happens in the market than everything widening the same 100 bps.
answered Nov 13, 2022 at 21:33
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$\begingroup$ Thanks for the explanation, but I don't understand why the desk sometimes looks at spreads narrow by 1%. i.e., a cash bond position contains a negative cs01 exposure, and positive exposures at credit spread tighten by 1% sounds contradictory in terms of the direction. $\endgroup$ Commented Nov 13, 2022 at 22:53
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$\begingroup$ When the credit spread tightens, a long bond position (or a short CDS protection position) makes money, positive P&L. I suggest you re-check whether your risk measures shows the P&L of the spreads widening or tightening (they may be different). $\endgroup$ Commented Nov 14, 2022 at 1:46