Why is there a structural bid for correlation?
- Banks using correlation to visually cheapen payouts through worst-of/best-of options is common practice for structured products.
- The sale of structured products, such as Altiplano (which receives a coupon provided none of the assets in the basket has fallen), Everest (payoff on the worst performing) and Himalayas (performance of best share of index), leave their vendors short implied correlation.
- Institutional investors tend to call overwrite on single stocks but buy protection on an index leads to buying pressure on implied correlation.
This buying pressure tends to lift implied correlation above fair value. We estimate that the correlation exposure of investment banks totals c€200mn per percentage point of correlation. Two correlation points is equivalent to 0.3 to 0.5 (single-stock) volatility points.
[me: correlation is another undiversifiable risk premium]