Correlation – the measure of how securities move in relation to each other – shot higher during the Lehman crisis and remains stubbornly high. Some observers note it is even spreading from individual stock movements into other asset classes and equity benchmarks. The trend is beginning to look costly for banks’ structured products desks. They, it turns out, are “short correlation”, which means they suffer losses when individual equities, indices or asset classes begin to move in tandem with each other. Experts explain this is because of the way many of their products, such as principal protected index-linked notes, are structured, utilising options against baskets of stocks or indices. When correlations increase, all the stocks move more closely together and the option price, which the trader is short, increases in value.Yet, in a painful move for structured product desks, correlation reached record high levels over the course of the summer. Those banks that did not hedge the risk proficiently, experts say, will have lost money.
Adding to the pressure will be the fact that correlation is a complex risk to hedge because, in part, of its implied and bespoke nature. Of course, in most cases, a bank’s preferred strategy will always be to recycle the risk directly through so-called correlation swaps with hedge funds and other enterprises. The problem is, with capital positions constrained by the financial crisis, hedge fund appetite for such products has been waning since at least 2007, experts say – which may have left large unhedged positions on investment banks’ books.
What is more, the prospect of getting hedge funds back into correlation products is not looking hopeful. There is less opportunity to do so now as there aren’t enough hedge funds with the ability to carry the positions. Hedge funds, simply, are going month to month, according to experts. Some say the lack of capital is creating supply and demand imbalances, with one big side-effect being the disconnection of correlation from volatility. They usually run together. Correlation is much higher than volatility would suggest. Industry experts insist that there is still a healthy bilateral correlation swap market for many, but to a lesser degree than pre-2007.
One alternative is through trading volatility – one of the fastest growing structured product offerings. Although experts are quick to point out, product design is only one element of a bank’s successful risk management policy. Experts are cautious and advise investors to consider supply and demand. High correlation makes some of the traditional long-correlation products less attractive to investors and consequently improves the pricing terms of structures that are short correlation. Not everyone, though, is comfortable with the idea of investing in products that happen to offset simultaneously a structuring desk’s more obscure risk.