Sunk by correlation

Equity Derivatives

Equity derivatives businesses have seen their revenues riven by losses during the first half of 2008. The malaise in credit, brought on by excessive US subprime mortgage losses, took hold of major equity markets earlier in the year. Subsequent spikes in volatility and correlation, combined with a drop in dividend expectations, have conspired to cause mark-to-market carnage for dealers' exotic books, which some estimate runs into billions of dollars.

"Everybody's looking at their exotic books. We've seen a whole series of two- and three-, if not more, standard-deviation moves. People never think the extreme moves are going to happen until they do," says Dan Fields, Paris-based global head of trading for equity derivatives and derivatives solutions at Societe Generale Corporate and Investment Banking (SG CIB).

Throughout most of December 2007 and into the beginning of January, 10-day historical volatility on the Dow Jones Eurostoxx 50 index drifted between 10% and 20%. But having been at 13.44% on January 17, volatility rocketed to a high of 62.89% on January 30. It subsequently receded to between 20% and 35% for much of February before spiking again to 39.43% on March 25.

Volatile markets usually make for trickier trading conditions - but crucially, this coincided with a sharp rise in correlation across global markets. Realised and implied correlations between global equity indexes, individual stocks and even between stock markets and some currency pairs have all soared. With most dealers short correlation as a consequence of popular structured products sold to retail and private banking clients, this delivered a painful blow to exotic books.

"It's not the products that are the most complicated from a financial-engineering perspective that would have caused most of the problems," says Neil McCormick, head of global equity exotics and hybrids at JP Morgan in London. "It would be those that have been around for many years, are high volume and have fairly low barriers to entry for a bank. The type of products would have been shorter-dated yield-enhancement products, typically with maturities between one and three years. They would involve people putting their principal at risk by selling options and trying to get coupons above the risk-free rate."

This encompasses products such as auto-callables, reverse convertibles and worst-of baskets. By referencing notes to baskets of stocks, investors are able to enhance coupons by taking a view on correlation. In the case of worst-of products, the payout is referenced to the worst-performing share in the basket. It is therefore beneficial when correlation is high and all stocks move in same direction, increasing the likelihood that the path of the worst-performing share is positive. The dealer, conversely, is short correlation.

The whipsawing in equity markets followed a widespread bull run in structured products issuance, which saw a flood of new players enter the market - many with little experience of handling unexpected spikes in correlation and volatility. Even for those that have experienced similar conditions in the past, the current dislocation has lasted longer than any previous disruption, says McCormick. "It's not the first time we've seen periods of high volatility and high correlation, but I think it's probably the largest and most prolonged move we've seen in those two parameters, and it's come at a time when the business is very much larger than it has been in the past," he says.

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