From direction to correlation
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.”
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.