The combination of comparatively high equity correlation and low credit correlation is tempting hedge funds to play derivatives of the asset classes against each other. To cater to them, some firms including SG Corporate & Investment Banking are pitching equity correlation swaps on baskets of names comparable to names in the equity tranche of credit-default swap indices.
The interested funds are predominately credit funds holding CDO equity, which took a battering last spring when credit correlation plummeted in response to a downgrade of General Motors Acceptance Corp (DW, 4/29). Holding this tranche gives the funds a long credit correlation position they may be able to off-set by selling equity correlation on a similar basket. Prior to last spring, it was popular to play the relative value of credit tranches against each other by shorting mezzanine against equity tranche holdings--this proved disastrous when the uptick in idiosyncratic risk, sparked by GM, saw the equity tranche lose value, and mezzanine gain.
Trading equity correlation against credit correlation is not for the faint-hearted, said one volatility arbitrage fund manager. Precise correlation instruments in both markets are relatively new and credit and equity correlation is driven by different technicals. While equity implied correlation is observable on indices, what is traded as credit correlation is actually time-to-default correlation.
Selling equity correlation against credit is not a perfect hedge, agreed a credit salesman. "But there's a real opportunity here--it's a very cheap way to leverage your view on credit," he added. Another hedge fund trader noted playing credit and equity correlation against each other is not a new idea but recent pricing levels make it attractive enough to reconsider, in spite of the imperfections of the instruments available.