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Correlation swaps. Next big thing or next big risk factor?
Theo Casey, a MoneyWeek managing editor, has looked at the fledgling asset class in more detail this week. In an article for Futures and Options Intelligence he concludes that for many investors . . . it’s probably the latter.
He notes, for example:
Correlation is the third of a spooky sisterhood, with dividends and volatility. Where correlation is today, dividends were in 2007, and volatility was in 2003. Namely an OTC swap-based asset class looking for its big break "“ a move to exchanges.
Correlation swaps themselves, his article points out, are based on the realised correlation of a pair of stocks. So the realised correlation of an index, such as the S&P Implied Correlation Index, is the average across all possible pairs of constituent stocks.
The swaps are hence derivatives of a derivative of a bunch of indexed assets.
Fans of the summer blockbuster Inception may appreciate the following — also from Casey:
In the summer blockbuster film Inception, I confess to having got a little lost once the third dream "“ the dream within- a-dream-within-a-dream "“ began. The way each pre-existing, prerequisite dream level impacted on the next was a little complex for me.
Thankfully, with the aid of the director's careful hand-holding and exposition, it all made sense in the end. As a consequence, a film with a complicated premise, with "art house flop" written all over it, has turned in more than $750m.
Banks, however, seem to be doing just the opposite. Rather than unravelling the complexity, they just portray these assets-within-assets within- assets as simple instruments. No more than absolute and relative value opportunities.
Nevertheless, for Casey, the products have seemingly arrived spookily on time. Correlations, after all, are trading at record levels. The near-dated S&P Implied Correlation Index, for example, rose last month to a lifetime high of 81.09 — an unprecedented level of correlation between stocks in the S&P 500.
As to what’s brought about this record level of unified stock movement Casey, like other commentators, feels it may be down to the unflagging popularity of index-linked funds like ETFs and other ‘delta one‘ trading approaches — all of which he says may be beginning to move the very markets they were intending to track.
He explains, with reference to the SPDR:
Spy is the most popular ETF, and the most heavily traded security in the US. It reaped more than 10% of total domestic equity trading in August according to data from Abel/Noser, with over $19.5tr of trades a day "“ more than five times as much as Apple, the next most popular stock.
Yet a big withdrawal of money from Spy would not hit the most overvalued stocks worst. The ETF would sell all stocks in proportion to their index weighting.
Hence stocks tend to rise and fall together when funds like this are most popular.
Ironically, though, this actually leaves many investment banks’ — largely through their structured products divisions — highly exposed to rising correlation. Unluckily for them, there’s currently hardly anyone eager to take the opposite side of the exposure.
Which brings about some reason to worry.
Among the high profile casualties of correlation over the years was of course Lehman Brothers back in 2007, Casey says.
And he adds:
This is a serious concern to banks struggling with too much unhedged exposure. Were correlation trading more popular, such episodes might be less common.
Related links: Stock picks tough as asset paths correlate - FT Did Socgen use ETFs to liquidate Kerviel positions? "“ FT Alphaville Did nobody ever consider that indexing was dangerous? - FT Alphaville
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