U.S. dealers active in issuing synthetic collateralized debt obligations referencing asset-backed securities are starting to hedge their exposure through correlation trades. Officials at Goldman Sachs and Deutsche Bank say they are trading ABS correlation through baskets of credit-default swaps referencing ABS, and Barclays Capital expects to have its correlation business up and running within months. European houses were beginning to look at ABS correlation plays last year (DW, 11/12).
Doug Warren, managing director and head of North American credit derivatives with Barclays in New York, explained when dealers hedge a tranche of a synthetic CDO, the dealer makes assumptions about how the underlying credits move together and the probability of their simultaneous default.
The best hedge is buying and selling the same protection, but this option is not always available, Warren said. Instead, dealers often buy protection on the mezzanine and equity tranches to hedge their exposure to jump-to-default risk and buy protection on single-name credits to hedge against spread moves. Correlation trading involves putting on long and short positions in various tranches and filling in the gaps using single-names, he said.
The corporate correlation market was hit hard in May after the ratings downgrades of Ford Motor Co. and General Motors Corp. led to a sudden drop in implied correlation, which exposed the deficiencies in how dealers measure it (DW, 5/20). Some players say the corporate correlation market must be sorted out before the market for ABS correlation can get underway.
One official noted there are only a few U.S. dealers in the ABS correlation market now, but he said this is set to change. The ABS market has already been more active following the publication of the CDS on ABS template by the International Swaps and Derivatives Association. He added plans are afoot to launch ABS indices by year-end on which swaps can be written but few details of the plans could be determined by press time. Indices will give way to more single-tranche trading, the official said, and this will boost the need for ABS correlation trades.