Dealers have been rejiggering delta hedges in their correlation books because the spreads on the underlying credit indices, which are used as delta hedges, have shrunk.
The spread move has been attributed to the sizeable constant proportion debt obligation flow, even though it was a few weeks back. That has had a "massive gamma effect," said one trader. A gamma effect is how much a hedge needs to be adjusted given underlying spread movements. In that burst of issuance, CPDOs sold protection on the indices in such size they altered the correlation between the underlying indices and synthetic tranches which the firms already held in their correlation books.
When dealers issue a single synthetic tranche deal, the rest of the collateralized debt obligation is replicated in their correlation book and paired with a delta hedge. In this case, dealers sell protection on the indices as their delta. "Your entire book [changes] when your delta moves," explained one correlation trader.
In a tightening spread environment, people want to get long on credit quickly and selling equity protection is the quickest way to take that view, dealers said. As a result spreads collapsed on the equity slices of synthetic CDOs while at the same time mezzanine spreads rose.
Equity and mezz tranches move with varying degrees of correlation. Since dealers are buying less equity protection, perversely it becomes more attractive to sell equity protection because it impacts mezzanine protection prices and shores up the correlation hedge.
Dealers have also had to rebalance the single-name positions referenced via bespoke deals. Some firms reportedly lost money in the shuffle although details could not be determined. The moves again show how fragile correlation models can be when market values tumble, some argued, as they did in 2005 with the Ford Motor Co. and General Motors Corp. crisis.
