A jump in correlation of European equities last week had traders responsible for hedging structured equity products scrambling to buy correlation. These books are typically short correlation, so they feel the pinch when correlation rises. An analyst said implied correlation shot up around five correlation points. This is not a significant move in historical terms, he explained, but derivatives houses have sold increasing volumes of equity basket products as plummeting equity volatility has brought down the price of structuring these deals and players have grown comfortable with a low volatility, low correlation environment.
Structured book traders were able to buy some equity correlation from hedge funds through basket swap trades, in which the fund pays the bank the realized correlation on a bespoke basket of stocks (DW, 12/23). Brokers said dispersion trades, a way of playing index variance against single stock variance, were also popular (DW, 6/20). But these trades are not hedges for structured desks as they offer exposure to implied correlation, which tends to trade higher than realized. One official noted the correlation spike will put pressure on derivatives houses to innovate their way out of short correlation positions with instruments such as the correlation option, priced by Credit Suisse First Boston in February (DW, 2/25).
