The material on this site is for financial institutions, professional investors and their professional advisers. It is for information only. Please read our Terms & Conditions, Privacy Policy and Cookies before using this site.

All material subject to strictly enforced copyright laws. © 2021 Euromoney, a part of the Euromoney Institutional Investor PLC.

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.”

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.

You have reached premium content. Please log in to continue reading.

Read beyond the headlines with Euromoney

For over 50 years, our readers have looked to Euromoney to stay informed about the issues that matter in the international banking and financial markets. Find out more about our different levels of access below.

SUBSCRIBE ONLINE TODAY

Unlimited access to Euromoney.com and Asiamoney.com

Expert comment, long reads and in-depth analysis interviews with senior finance professionals

Access the results of our market-leading annual surveys across core financial services

Access the results of our annual awards, including the world-renowned Awards for Excellence

Your print copy of Euromoney magazine delivered monthly

£73.75 per month

Billed Annually

FREE 7 DAY TRIAL

Unlimited access to Euromoney.com and Asiamoney.com, including our top stories, long reads, expert analysis, and the results of our annual surveys and awards

Sign up to any of our newsletters, curated by our editors

LOGIN NOW

Already a user?

We use cookies to provide a personalized site experience.
By continuing to use & browse the site you agree to our Privacy Policy.
I agree