nIYATIVES

Ihe
lastpiece of
oo
ellgsaw
Derivatives
experts are desperutely searching for a way to
measure
and hedge the last frontier in derivatives
-
correlation
risk. Without this element, pricing models do not
-,rk
properly, particulady in newer products such as dffi
;tYaps.
By Mark Parsley
./eryone, it seems, is looking lor a theory oF
-reryrhing.
A long-standing quesr in physics,
the seerch [or a unifring theorv has spread to
rhe finrnciel rvorld.
The models that asset managers use to
I
:lxnage portfblios and those used by deriva-
I
.s d."l.rs to price and hedge options work I
,-.t ,,f rhe rime- hrrr sonre of rhe rime rhev
don'r work at all. Something is missing that
rvould complete the picture. I'he picture in
this cese is the term structure of interest rates
and inrerest rate volatiliry, and their relation-
ship rvith loreign currency rates and equiry
PflCeS.
The rocket scienrists of the financial world
have become obsessed with a phenomenon
r)st of rhe tirne, but some of the time rhey
that they cannot price or hedge directly but
rvhich rhev see as the frnal piece in the jigsarv
of risks they must understand and control if
rhey are to manage portfolios effectively. That
phenomenon is correlation.
Identif,ving and quantifring correlation risk
has become the derivarive markets' holy grail.
The risk itself is nothing nerv.
'When
dealers
talk about rhe term structure ofinterest rates
-
the relationship of rares at one point in the
curve to rates at another point
-
they are ralk-
ing about correlation.
\X/hen
lurures traders
with long-dated positions worry abour future
inrerest rate movements and their relationship
with rnargin calls and the cost of borrorving to
cover them, they are lvorrving about a correla-
rior-r effecr. lvlodels rvhich take correlation into
account are believed to be behind sudden
corrections benveen futures and rrur. (fonvard
rate agreement) markets.
Long before ir became a buzzword, people
were losing n-roney because they did nor
understand the effecrs of correlation.
-lraders
ofren ran their portfblios of caps and srvap-
tions together, assuming a correlation of one-
a perfect correlarion berween movemenrs in
rhe volatiliry of the rwo products.
Caps, portfolios ofindependent options on
interest rates, and swaptions, single options on
portfolios of interest rates, are clearly related
in price. Horvever, the relationship depends
not only on yield curves and rhe volatilities oF
forward rates, bur also on a correlation matrix
of rhe volatilities of forward rates. Any book
conraining borh caps and swaptions is a corre-
lation book. Because srvaprions generally trade
at lower volatilities than caps, dealers saw an
easy arbitrage: sell cap volatiliry and buy swap-
rion volatiliry. In fact, the volatiliry correlation
is more complex than they believed, the
volatilities did not converge and these trades
periodica.lly made significant enough losses to
make many dealers separate rheir portfolios.
Deeper understanding
As profit margins are squeezed, the managers
of these porrfolios, realizing that this is inelfi-
cient
given the element oF correlation rhat
does cxrst. are studying ways to incorporlte
correlation inro their models. In rhe rvorid of
interest-rare products, the rheory of every-
thing being sought is the model that will
enable them to price all contingenr interesr
rate claims using one volatilirv model.
'At
present rhese kinds oF models rvould
probably require a Cray
[supercomputer]
because rhey would have to iterare out the
whole rerm structure oF interesr rates, but it
might be possible," says Alex \7att.s, a director
ar Sakura Global Capital. "\What
has driven
rhe markets fbr the lasr half dozen years is co
incorporate more instruments into one model
or theory. The locus on correlation is not a
Fundamental change, its just that people's
basic understanding of swaps and options is a
lot betrer than it was five years ago. We under-
stand volariliry better; 6rst it w'as bought and
sold as a commodiry; then Black-Scholes gave
us a lramework for valuing itl now we can
E.urontoney
I
November 1993 2)
.l
I orRrvruvns
i-
I
fh**
:i!
could ha,ue bought cheap Bund/oer spread
options from houses rvho believed rhat the
snv would cause them to move in lockstep.
The mosr popular correlarion product (also
second-order) is the differential swap, or diff,
and it is largely rhe surge in diffvolumes rhat
has prompted dealers' interest in correlation.
Indeed, rvhen they talk abour correlarion risk,
many dealers mean specificallv rhe risk creared
by rheir assumptions on rhe correlation
berween an interest rate and an exchange rate
rhar is embedded in a diff.
"The diffproducr made correlation risk rhe
most importanc thing rhat distinguished ir
From an inlerest-rate swap or cross-currency
swap. This is because rhe bias in the price o[
rhe product is directly a consequence of rhe
co-variance and the mosr important input
into the co-variance is the correlation berween
some oF rhe underlying paramerers," savs
\Watt.
Diffs are easy to describe and almosr impos-
sible to hedge. The srvap rvriter undertalies ro
receive Libor in one currengv, usually dollars,
and to pav Libor in another currency with that
payment srream denominated in dollars. This
creates nvo correlation problems.
First, the dea.ler is exposed to the correla-
tion benveen the rwo Libors. This can be
avoided relatively easily using a pair ofinterest
rate swaps, by buying bonds or using lutures
OT FRAS.
Second, there is the correlation berween
interesr rates and Fx rates. Suppose the swap
writer is paying Deurschmark Libor in dollars
and receiving dollar Libor. He is funding the
Deurschmark Libor payout through the
Deutschmark swap marker, so even if interest
rates remain the same he is exposed to rhe risk
that the dollar will strengthen leaving him
short of Deutschmarks to pay off the dollar
liabiliw. Hedging this risk means taking a view
on the correlation berween interest rates and
FX rates.
Does the bank believe that a rise in
Deurschmark interest rates will affecr the
$/Dm rate? If so, exactly how strong is the
correlation effect
-
to what extent does rhe
bank believe that any rise in Deutschmark
rates (and so in rhe amount of money it must
pay out to the counterparry) will be compen-
sated for bv a srrengrhening of the
Deutschmark against the dollar?
"Cusromers are basically getting the bank
to remove the uncertainry berween the rela-
tionship of interest rates and currency values,
that is to guarantee that movements in Euro-
pean interest rates will have no impacr on rhe
value ofthe currency. The problem rve have is
that if we take a position ro hedge against the
most likely scenario, rhat is that when Euro-
pean rates fall European currencies will
weaken, and it doesn't happen, then rve lose
money," says Ronald Tanemura, a director at
Salomon Brothers.
The correlarion problem in rhe case of diffs
is particularly acute. A corporare hedgert
rarionale For using one shows why. Before rhe
rnv melrdown, a corporation with Libor-
manage volatiliry in a portfolio of options.
Correlation is the next stage."
Everv long-dared option contains a correla-
tion component berween interest rates and the
underlving. V4rat matters to the price of an
equiqv call, For example, is not todayt spot but
the lorrvard price. The forward price is the
spot plus an inrerest rate component. If an
option rvrirer believes thar there is a correla-
tion benveen equiry prices and interest rate
moves
-
such as the apparent negative correla-
tion benveen the rwo at present
-
then simply
tracking rhe historical volatiliry of spot is an
illogical hedge, implying as it does zero corre-
lation.
Horvever, the present wave of interest in the
sub.ject srems from a Salomon Brothers issue
o[ dollar-denominated Nikkei rvarranrs in the
mid-r98os. Although Salomon rook a while to
realize that ir had created a whole nerv class of
currency-protecred derivatives, Cred.it Suisse
Financial Products and Bankers Trust saw it
immediately. The quanto ivas born.
The first equiry quantos rvere second-order
correlarion products. That is, the correlation
co-elficient (the number berween plus one and
minus one that indicates how well assels are
Cha-se Manhattan's llartin Cooper lavours practical, numerical ways ofhedging correlation products.
correlated) is nor applied to the option pavour
directly. Take the dollar-denominated Nikkei
warrants. The exrent ro rvhich the Nikkei rises
or falls rvhen the ven strenqthens againsr the
dollar only affects rhe oprion pavout indi-
rectly: its effecr is correlation times exchange
rate volatilirv rimes Nikliei volatilirv.
The potential effects of correlation on pric-
ing (and therefore on hedging) lre more intu-
itively clear lor first-order products, those in
rvhich correlation directlv affects the oprion
payout. The commonest of these are spreed
and outperfbrmarce options.
Diffswaps puzzle
Clearly, no one rvill pay much for a spread or
outperformance option on rwo assets rhev
believe are highlv correiated. Similarly, the
more confident rhe option seller thar the nvo
assets are highlv and srably correlated, rhe less
hedging it rviil r,rndertake. A decrease in the
correlation benveen the underlying assets,
such as a reduction in the volatiliry of one oF
them, may increase rhe price of the option.
Differing beliefs on correlation could
clearly affect rhe market: an invesror rvho
believed thar the ER-\{ was going to lall apart
i0 Euromonev
|
\ovember 1993
based
sterling liabilities found itself paying
interest
rates that bore no relationship to thi
economic
environment in which it operated.
Treasurers
saw that us rates were more obvi-
ously
tied to the real economy and decided ro
rake
advantage of this by opting ro swap
dollar
Libor for steriing Libor in dollars. Ifthe
,
s recession were prolonged, dollar Libor
;uld remain low, rvhile levels of political
.i-rpporr for high European interest rares
iooked srrong. The political and economic
factors that drive rx and interest rate correla-
tions make rhose correlations difficult to
predict and subject to sudden, exrreme move-
ments,
Need to quantiry
So how do dealers hedge rhe risk? The simple
nswer is that they don't. "Correlation
risk is
jsentially
unhedgeable," says one rrader.
'Providers
of these products are taking corre-
lation views, over- or under-hedging and basi-
'[y
being oprimisric rhat rvhat is
.redgeable today will be hedgeable in a
.rple of years." They can overhedge wirh
expensive foreign exchange options, disirable
be.ause diff pricing is related to rx volariliry
and is therefore option-like, or in rhe interesr
iate futures markets.
tVhile
margins were fat, this .imprecision
Jid nor matter. Banks builr prorection into the
price o[ the producr. In first-order correlation
products, such as yield-curve options, spread
options, basket options, better-of-rwo-asset
options and cross-currency caps, where corre-
lation directly affects rhe'opti,cn payout, this
margin might range from
5o
basis points (bp)
to over roo bp. In second-order products such
as diffs, providers could proteit themselves
against moves in correlation from o.r to r.o for
:.o bp.
Now that margins are being squeezed, deal-
ers are much more concerned to quanti$, and
hedge correlation risk b.cause incorrecr
assumprions will cost rhem their profits.
-
"\7e
are gerring ro a level where these things
ter. ?eople are saying,
'o.re
vega *is
pposed to rranslare into a certain
pe<i
and it
didn't. \X.\ry nor? Oh. rhere was ln inreresr rate
move at the same time. \7e should srudv rhat
rorrelation so rhar we ger a more predittable
?s(L'," says one banker. "The
problem with
correlation is that it is often se.n as a second-
order effect and ignored. The snag with not
quandfi/ing it is the same as if you ignored
Samma
in options rrading. Over rime you cxn
6nd yourselFwirh
a probiem
rhar has t".o-.
E rst-ord.r-
"
order effect, the currencv', is difficult. Assum-
ing vou've got rhe inreresr-rare hedge locked
up, you have ro focus on the correlation risk
because it is the orher risk you have. Now, no
matter what rhe correlarion benveen rx and
inreresr rates, rhe impact upon your
p&L
is
going to be minor compared to what will
happen iF you don'r hedge the interesr rate
risk. But rhose variances can move around and
wipe out your profit margin."
More than rhar, traders are nor comfortable
with risks they do not understand. It is fine to
have exposures, even outrighr exposures but it
is not acceptable ro have an exposure that is
not understood. As yer, there is more mathe-
matical musing on the correlarion problem
than practical solurions to it. There is little
consensus on wherher correlation is stable
enough a paramerer to be used in pricing
models. There is hardly more agreemenr on
how it should be measured: one side argues
that the apparenr instabilirv of corre.lation is
due to measuremenr inadequacies; the other
counters rhar the instabilirv is perfectly clear
From the hisrorical dara.
Much of the work being done at the
moment falls broadly into rhe category of
measurement.
.Some
people concen_trate on
improvemenrs in measuring historical correla-
tion, others wreJde wirh rhe embryonic
science of stripping implied correlation from
existing options. Improvements in measure-
menr techniques for hisrorical correlation are
concentrated on garhering more data and
measuring correlarion over shorr periods of
Implied correlation is more difficult ro find,
but is the more valuable prize, because it holds
the key to hedging correlation risk itself.
Correlation is fundamentally difficult to
hedge because there is no marker in which it
can be boughr and sold directly
-
in much the
same way that in the early days of the options
market there was no real gamma market.
Option sellers could delta hedge their primary
market risls, bur were unable to do much
about second-order convexiry effects. These
days, with liquid options markets a1l priced off
the same assumptions, gamma trading is run-
of-the-mil1.
Dealers foresee the crearion of such markets
for correlation risk
-
but nor yer. For example,
in the same way rhat an FRA is the basic
componenr of a srvap, so a diff
pne.
would be
the basic componenr of the differential swap
and cross-currency swaprion. However, in rhe
near Future the focus is on pricing rhe correla-
tion component wirhin existing products.
'J(hile
academics publish theorerical solu-
tions to the diff swap problem, the six ro 12
producr leaders are sharpening up rhe pracri-
cal side, where possible isolating rhe market's
valuation ofcorrelation. In this way they hope
to pur rogerher an overail picture ofwhere the
market prices the correlation benveen as many
markets and as many intra-market variables as
possible.
Not only is this necessary if dealers are to
quanti8/ their own portfoliot correlation posi-
tion, ir is also the only way in which they can
use_exisring products ro hedge rhar exposure.
"One
way to hedge it is obviously ro create
other products thar have offserring correla-
t.ions. You need to have the sysrems in place to
monitor the risk so rhar you
know when to
hedge, what transaction ,o .r.rr. ancl what
exact characreristics that instrument should
have ro flarten our your risk," says one hedqer.
Stripping implied correlation from fiisr-
order producrs is reasonably intuirive. Volatil-
iry is a traded commodiry and so implied and
historica.l volatilities are generally viry close.
Having a good idea about rhe volatiliry levels
used by the various providers of, say, spread
options means rhar by comparing rhe prices of
identicai instrumenrs their views on correla-
tions can be guessrimated and valued.
Ifa house believes rhar rhe volatilities ofthe
underlying assers are more closely correlated
than recenr historical spread volariliry implies
and than the implied correlation of ih.ir
comperirors' products suggesrs, then rhey will
price a spread oprion below rhose levels.
Pricing off the street
The problem with applying the numbers
generated in this way is that it is not clear that
many market parricipanrs scientifically pr.ice
correlation inro their products. Implied
volatiliry closely follows historical livels
because volariliry is so firndamental an input
into options pricing models. Correlation is
not as important
-
indeed spread options are
priced by the Black-Scholes model wirhout
reference to correlation because the spread
itself is used as the underlying asser. Mulri-
factor models do take coirelation into
accounr, bur getring meaningful implied
correlation numbers involves mor. ihr.t
simply ca.lling rhe difference in rwo houses'
pricing of a spread option the correlation
component.
The division of producrs into firsc- and
second-order encourages this confusion and
can be unhelpful. Diffs are second-order
'orrelation
products, but that does not mean
,rat the correlarion element is trivial. "lf
a
customer
wanrs ro go long European interest
rates
and diff rhem back inro dollars, then I
am
short rhe market, I've gor ro buy bonds,"
says
one diff writer. "Obviously
buying the
bonds
is much more imporrant than
-i.,rg-
tng
rhe Fx risk, but it is simple. The second-
"The problem with
coffelation is that
it is often seen as L
second-order effect
and ignored"
Euromoney
I
November 1993 J1
Aiso, the small number of banks able ro
offer correlation-related products means that
effort devoted to srripping out implied corre-
lations ohen resuks simply in confirming that
everyone is using rhe same practical mix oF
historical correlaiions plus a [irrle exrra for
possible deviarions.
.
"People
are generally practical. They look at
how everyone else is pricing and unless they
think somerhing is drasricrlly our, rhey will
price in the same ballpark," says one deriva-
ilves exPert.
DBRIVATTYES
-
That said, the number of players in this
market is so small that any head start in rhis
process, even ii: ir means using the competi-
tion's products to hedge, is vital. So sensitive
are major plavers about ways of laying off
correlation risk that many will nor discuss
these kinds oI strategies.
Proxy hedging
"In the diff swap there are other instruments
in the market rvhich have similar embedded
correlations rvhich have some liquidiry which
you can go in and our ofto match your book.
Ifyou have good systems and can quanriry the
correlation risk, vou can hedge it and flatten
out your book. But just what they are id
rather not sa)'," says the derivarives chief at a
large us instirution. "It's not even clear that
the people rvho are trading those products
understand that rhey have those correlations
embedded in."
For example, the rx/interesr rate correlation
in a diff is an economic variable. The correla-
tion element might be hedgeable using an
equiry quanto in which, again, an economic
correlation is embedded. So if German rates
fall, the Deutschmark will weaken but the oax
will rise: the bank will pay less out on the diff;
however, in some related ratio it will have
fewer Deutschmarks to convert into dollars to
pay out under the swap. But again, in some
related fashion, this shortfall will be compen-
sated for by a rise in value of the equiry
quanro. Ar least thatt the idea.
Equally, path-dependent options contain a
series of correlarion assumprions that under-
pins the way in which the house writing and
hedging them beiieves the path of the under-
lying will develop. At presenr, when looking at
path-dependent options most people use
binomial methods or Monte Carlo simula-
tions (a numerical approximation) to generate
distributions. This is increasingly seen as too
simplistic. The search is on for a way of re-
modelling these options to take correlation
into account and initial attemPts show
marked differences in price.
Correlation-dependent instruments inc-
lude amortizing rate swaps, in which the buyer
receives a high fixed-rate payment in exchange
for taking the risk that the swap principal will
amortize according to an index that represents
either real or synthetic interest rates. In
essence the buyer has granted the seller a path-
dependent interest rate option that contains
correlation assumptions that can be crysta1-
lized to some exrent by breaking the option
inro a bundle of caps and swaprions.
It is true that this kind of prory hedging
was used in the eariy days of other options
markets. However, the problem with trading
complex correlarion-related products such as
diffs to hedge correiation risks dynamically is
the lack of consistent rwo-way flow in either
the insrruments or the views they represent at
any time. Afthough rraders claim to see trad-
ing in dills and cross-currency caps, they
admit that clienrs tend all to rvant to make the
same bet at the same time. "You can use fancy
we lose money"
models like Garch to work out probable distri-
butions and look at implied correlations but
none of that is much good when ail the trade
is one-way," says one derivatives chief
In rhe longer term the search is for correla-
rion outside the lew illiquid products offered
by the elite. Martin Cooper, head of Tieasury
New Products at Chase Manhattan in London
and a champion of practical, numerical meth-
ods of hedging correlation products, believes
that one of the only liquid products from
which you can strip our implied correlation
with some degree oF accuracy is foreign
exchange options.
"You
can think ofan Fx option as being on
rwo assets," says Cooper.
"lf you know the
volatilities oF options on I/Dm, cable
[9I]
and $/Dm, then by plugging the volatilities
into a pricing model you can imply the corre-
lations." The lower the volatiliry of the cross
relative to the volatiliry of the individual
components, the more highly correlated the
rwo exchange rates,
Cooper believes that if you accePt this way
of looking at Fx options, you can take posi-
tions in implied correlation by buying and
selling volatiliry to remain vega neutral. Vega
measures the change in an option's price
caused by changes in volatiliry. A vega neutral
position, one that is indifferent to small
changes in volatiliry Cooper says, can be seen
as a correlation position.
Being able to work out implied correlations
from FX options enables banks to develop a
systematic way to substitute exactly one
oprion position for another - for example, ro
hedge an option on an illiquid cross in more
liquid markets.
No bookrunners yet
Howevet correlation trading in this way is
more theory than practice. In theory, sellers of
correlation-dependent options make money if
markets are more correlated than is implied in
the options in the same rvay that they will
make more money if they sell an option with a
higher implied volatiliry than actual. In prac-
tice, the science ofpricing options rvith precise
implied correlation coeficients is embryonic.
Even if ir is being done on a transaction by
rransaction basis, there is no model as yet lor
monitoring correlation on a portfolio basis.
"No one rhat I know of can run a portfolio
of different correlation risks together. Thar is
just theory. In terms oF practical experience
"If we hedge
against the most
likely scenario and
it doesn't happtr,
AIex Wrtt:
"We
understrnd volatilin* bctter.
no-onc can pur together a book o[ thcse
different products rnd hir i button lnd sa"'
this is my corre iarion risk benveen tl-ris
cLrrrency and this intercst rare and so r>n. Tha.
doesn'r exist ar the moment. It rnight exist in
tz months, but ir doesn't exist :rr rhe momcnt.
The best you could do is mavbe hedge corre-
lations at particuiar maturin' buckets, as vou
rvould a clsh or srvaps book." says one hedqer
grappling rvith correlation problems in his
cap and srvaption porrlblios.
Nleanwhile. as far ,rs the clients are
concerned, correlarion is oF Iimited direcr
consequence. Thev do nor generally rvorn-
about correlations benveen their fbreiqn
exchange positions bevonci basic assumptions
on verv closely correlated currencies such as
Dm/Dfl. Thev certainly do not look at their
exposurc to correllrion, benveen inrerest rates
in one currencv and e-xchange rates benveen
rhar currencv rnd anorher.
From their point of r.ierv, a better uncie r-
standing of correiations on the part oi their
dellers will meln finer prices. more consis-
tency of pricing benveen reiated products
-
such as caps and srvaptions, and a greater vari-
ery of risk management products. $7hen the
unificd theorv of conringenc inreresr rlre
claims is finallv cracked. ii it is, thev rviLl
beneiit From a better understanding of rhe
way interest rates work. No one is predictine
when thar mighr happen. I
J2 Euromonev
I
November 1993