Equity derivative houses are scrambling to innovate themselves out of the short correlation position they have built up through selling structured equity products. Dealers are looking to encourage hedge funds to sell equity correlation through variations on basket correlation swaps, which have so far only been traded in small volumes (DW, 6/20).
The pressure to create a liquid market for correlation weighs on U.S. houses in particular. Under the Financial Accounting Standards Board rules some U.S houses are unable to book first-day profits for the structured products they sell because there are no observable market prices for correlation.
Banks pricing index correlation for hedge funds is in a step forward from correlation swaps on baskets of stocks. "There's a push to standardize this product," said Carl Mason, equity derivatives analyst at Deutsche Bank in New York. Correlation is the last major piece of risk that can't be hedged in the market place, explained Mason. "I think that the correlation product is certainly the next wave of innovation," he added.
Siggi Thorkelsson, head of equity derivatives trading at Lehman Brothers in London, agreed there is a need for dealers to buy correlation. "Dealers have a finite capacity and correlation is trading at high levels," he noted. Lehman has entered dispersion trades with hedge fund but Thorkelsson says these are not convenient. For example, a 50 stock dispersion trade executed through straddles would actually require 150 trades.
Equity houses are looking at ways of stripping out the volatility element of a dispersion trade, which would leave only the correlation exposure, according to Mason.
