Credit Suisse First Boston has priced the first option on equity index correlation and other dealers, including Deutsche Bank and SG Corporate & Investment Bank, are thought to be close on CSFB's heels. The innovation is driven by houses that have sold correlation through retail structured products and need to buy it back in order to carry on selling structured products.
A hedge fund manager who was pitched the trade on three-year Euro STOXX correlation explained it has a call option payoff, but instead of referencing a stock's price, the dealer calculates the average historical pairwise correlation of the index components. The CSFB deal is novel in that it offers exposure to index correlation. Structured product houses have traded correlation swaps, in which banks and funds exchange a payout linked to the realized correlation of bespoke stock baskets, but these don't have mass appeal because the hedge fund doesn't pick the stocks (DW, 12/23). In addition, some banks have traded options on these, but the major difference is the baskets are identical to the ones the bank has sold to retail investors. Officials at CSFB, Deutsche Bank and SG CIB declined comment.
Most banks looking to buy back correlation admit hedge funds have a limited interest in selling correlation. "There are no good models for pricing this stuff," said one exotics trader. Bank officials, however, believe options on correlation may have more success. "An option means you have an upfront payment, so you benefit if correlation falls and you do not hurt if correlation rises," explained one analyst.
Hedge funds and derivatives houses have traded correlation for some time through dispersion trades, usually by playing variance swaps on single stocks against variance swaps on their index. Although dispersion trades through variance swaps could be used to manage correlation instruments such as options, one equity derivatives analyst noted not all single stock variance swaps are liquid enough to effectively hedge the trade. "Structured product desks want to offload their correlation risk any way they can," noted the analyst, who said getting rid of some of this exposure is more important than being able to accurately price correlation instruments.
