Correlation Pop Hits The Shorters

Some equity derivative dealers and hedge funds were caught short correlation last week as rattled stock markets prompted a sharp rise in correlation while putting pressure on liquidity.

  • 26 May 2006
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Some equity derivative dealers and hedge funds were caught short correlation last week as rattled stock markets prompted a sharp rise in correlation while putting pressure on liquidity. Correlation has been driven lower over the past few months as merger and acquisition activity has picked up, pushing single stock vols out of whack. But inflation fears have seen global stocks lose value across the board, sending correlation to year-long highs. On the Euro STOXX 50, implied correlation went to 65% Wednesday, from 42% the previous week.

One structured equity trader said losses connected to rising correlation will have been cushioned by profits since the start of the year. "While we're talking hefty losses, it's maybe 2% of the year so far," he said. The situation is more of a problem for hedge funds that publish monthly NAVs, however, and face the specter of investor redemptions. It comes on top of losses from short volatility positions funds may also have been running (DW, 5/22).

Selling correlation through buying index volatility and selling single stock vol has been attractive partly because it has been positive carry. One inter-dealer broker estimated some dealers were making EUR100,000 a day by maintaining short correlation positions. When it became clear--after a short-lived surge last Tuesday--a quick correction was not on the cards, dealers and funds looked to close out short correlation positions, but lower levels of liquidity due to increased risk aversion meant even those who got out early may have registered losses.

"It's a crazy time right now," said the broker, noting uncertainty about the duration of the volatility and correlation upswing makes players unwilling to put on structured positions. On the upside, however, there has been demand for forward-starting variance options--which give the right to enter volatility and correlation positions at a later date. Most buyers seem comfortable with the idea volatility and correlation will come off in one to two months, and are buying forward-starting variance to play out this view.

  • 26 May 2006

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