Deutsche Bank's U.S. prop desk has started pairing equity variance swaps against the high-yield and crossover series of the CDX index. The firm is also starting to recommend the trade to clients, and it is believed to be the first house on the Street to do so.
There is a correlation between equity volatility and credit spreads. The idea behind relative-value trading the two asset classes is to capture any mispricing. This has been difficult to do but increasing liquidity of instruments such as variance swaps for playing equity volatility and credit-default swaps for playing credit spreads is now making this possible. Firms including Barclays Capital and Citigroup have been publishing research in this area for some time (DW, 12/15), but most have focused on playing single-name credit-default swaps against single-stock variance swaps rather than the broader indices.
The two legs of the Deutsche Bank trade are believed to be going long volatility via long-dated, four- and five-year Standard & Poor's 500 variance swaps while selling five-year protection on the 0-10% tranche of the high-yield credit index.
Several market participants on the credit side, however, questioned whether the index play would capture the inherent correlation between equity volatility and credit spreads because there is little overlap of the names in the two indices. But hedge fund players straddling both credit and equity said the trade could be a smart long-term bet on the effects of increased leveraged buyout activity on debt and equity.
The expansion of the trade from an exotic prop desk play to an institutional sale is being attributed to the arrival Cory Carlesimo, who joined Deutsche Bank in May from Merrill Lynch. Carlesimo leads the firm's equity derivatives sales team and he brought a slew of clients looking to place the more sophisticated trades that Deutsche Bank was working on. Carlesimo and officials at Deutsche Bank declined or were unavailable for comment.
