A variation on a credit versus equity trade emerged last week that has structured trading desks buzzing. One sophisticated account, believed to be a hedge fund, reportedly entered a five-year EuroSTOXX 50 correlation swap, selling equity correlation as a relative-value play against the equity tranche of a collateralized debt obligation or credit index. The deal caught the eye of officials because while five-year index correlation swaps are traded in the inter-bank market, the long end is less common with customers and deals that go through tend to affect the volatility curve of the index.
The counterparties to the trade could not be determined and it did not appear to go through an inter-broker dealer, but rather was a direct trade between a bank and hedge fund client. One market official speculated there are only a handful of houses that could price the trade, and the customer would likely have only called two or three in order to keep its intentions under wraps. While it is unlikely to be a trade which starts a new trend, said one official, it is also hard to tell if it was driven by client demand or structured-book hedging by a bank.
Several officials noted playing equity correlation against credit correlation is a dangerous game. "It's what you would call a Texas hedge," noted one equity strategist, who explained it's essentially a risky position rather than a hedge. He noted it makes more sense as a macro-event play: in a market-event situation triggering a drop in credit correlation the equity tranche holder might register a mark-to-market loss, but gains on the equity correlation swap could partly compensate for those losses.
CDO equity value increases as credit correlation rises because risk of idiosyncratic defaults falls. This tends to happen in distressed market situations, as witnessed last spring when auto-sector downgrades punished hedge funds holding CDO equity. In comparison, equity correlation tends to increase when there is a market event, and this is when the credit/equity play may make sense, said one official.
"There's been a lot of study in [debt versus equity trading], and it's something everyone is talking about," said one exotic equity desk head. But while capital-structure trading has been tipped as the next big thing for some time (DW, 12/10/04), it has struggled to take off. This is partly because of the difficulty in modeling the correlation between debt and equity, and also because even at derivative houses which have combined their credit and equity sales forces, only a few firms run credit/equity hybrid trading books.