The relationship between the creditworthiness of the hundreds of names that might be referenced in a CDO creates a new risk category. Default correlation risk is the risk that one default makes another default more likely. In a simple example, a default by a major supplier might increase the likelihood of a default by one of its customers. High default correlation in the underlying reference portfolio doesn’t just make investing in a CDO more risky overall. It alters its payment profile. Higher default correlation means closer risk profiles for both junior and senior investors. Low default correlation should mean greater pricing differences between junior and senior tranches.
So the CDO market, which first grew by letting investors take a directional view on underlying credits, now enables investors to take a view on the correlation of different tranches. “Correlation is starting to trade just like volatility in the interest rate markets,” says Andrew Palmer, global head of credit derivative marketing at JPMorgan. “Correlation trading should make credit risk transfer more efficient.”
Inconsistent pricing
Correlation trading is a useful risk management tool for credit derivative desks and enables hedge funds to benefit from the risk positions that some houses have built up. But are the different levels of correlation being accurately priced?
Some banks are said to be taking advantage of the lack of an industry standard. If their own models for calculating correlation deliver a low result on particular tranches, these are marketed heavily to investors. “I don’t know that people are deliberately selling stuff that they shouldn’t be, but that is a risk when a market like this is in its early stages,” says one market participant.
Implied volatility, as used to price interest rate or equity options, doesn’t suit CDO tranches because while an option has one property – its strike price – that governs its relationship with volatility, a CDO tranche has two – its upper and lower attachment points. And with 100-plus names in a CDO’s reference portfolio, each with its own curve, implied correlation models can be time-consuming and impracticable.
The market needs an unambiguous and universally accepted way of pricing correlation. “In the equity world, options price to volatility and vice versa. If the credit derivatives market can price correlation in a consistent way, the actual model chosen doesn’t matter,” says Lee McGinty, head of credit derivatives strategy for Europe at JPMorgan. “The goal is to produce something that is easy to understand and easy to reproduce.”
In May Moody’s announced that it would distribute two new models for measuring underlying credit risk on static synthetic CDOs. They include new assumptions for inter- and intra-industry asset correlation.
Again, the market wants consistency. “Even the rating agencies can’t agree,” says Dominic Powell, director of investment solutions at Henderson Global Investors. “People are still trying to get to grips with this. And in circumstances of extreme volatility, models start to break down.”
