Mapping A Market For Correlation

David Krein
November 01, 2007

 Cover PhotoThe equity bubble collapse in 2000 revealed the severity of correlation risk within many portfolios, leading investors to shift significant capital away from unexpectedly similar exposures to a wide array of alternative asset classes, markets and products in the belief that doing so would mitigate such risk. After all, modern portfolio theory may no longer be able to boast of a sterling reputation, but every financial professional understands its implications: A portfolio of uncorrelated risk assets should have a higher risk-adjusted return than any individual asset within that portfolio.

Unfortunately, several markets and asset classes that have historically had low correlation have become highly correlated in recent months and years. A strategic asset allocation policy established with low correlation expectations now functions in a high correlation environment, and may offer diminished diversification value relative to the less-correlated historical performance observed over a longer time frame. The market gyrations that reverberated around the world in August 2007 have since pushed correlations even further toward 1.0. Equity markets and other risk assets repriced lower, as many investors headed for the exits simultaneously, while short-term Treasuries climbed rapidly in the ensuing flight-to-quality. Investors were sharply reminded that, in times of market stress, there are few safe places to hide.

Although such relatively high correlations could persist, correlation is often volatile and may revert to lower levels in the near future. It is exactly when the uncertainty runs this high that investors are most in need of correlation information to make optimal portfolio and investment decisions. More specifically, investors everywhere would benefit from access to the information “building blocks” of correlation: forward-looking, market-based correlation expectations. The potential benefits of access to such building blocks are significant. For example, forward-looking correlation expectations can incorporate the aggregate opinion of the economic cycle and macroeconomic data, legal and regulatory developments, mergers and corporate actions and earnings. Furthermore, correlation expectations can react rapidly to new information as it becomes available, yet remain insulated from stale information that is no longer relevant. Despite these potential benefits, there are no correlation indexes or benchmarks for observing correlation expectations, few securities for pricing correlation risk and no markets or exchanges for transferring correlation exposure. The innovation has thus far been underwhelming at best.

Volatility Markets

Fortunately, we find a broad road map for the development of such forward-looking instruments in the volatility marketplace. Like correlation, volatility is a critical risk factor. In contrast to correlation, however, volatility has seen tremendous growth in the availability and use of forward-looking, market-based risk products. In fact, equity and index options are among the fastest-growing segments of exchange-traded derivatives. Volume has jumped dramatically in each of the last few years, and almost doubled from 2004 (1.08 billion equity contracts and 98 million index contracts) to 2006 (1.84 billion equity contracts and 186 million index contracts).

As August 2007 came to a close, we saw activity pushed even higher. The year-to-date total (1.64 billion equity contracts and 180 million index contracts) rivals the total for all of last year, and on August 16, 2007, the U.S. options markets had their single busiest trading day of all time (20.2 million equity contracts and 3.5 million index contracts).

Investors are also turning to the “VIX,” an innovative volatility index, to manage their expectations and portfolio risk. Formally known as the Chicago Board Options Exchange (CBOE) Volatility Index, the VIX is a forward-looking, market-based measure of 30-day expected volatility for the S&P 500. The CBOE first introduced the VIX more than a decade ago, and introduced VIX futures and options on VIX futures nearly two years ago. The benchmark itself is now as well-known as other major market indicators, and trading activity in VIX-linked products has taken off. On August 16, 2007, volume hit a record 315,000 option contracts with more than 2 million contracts of open interest.

Equity and index option volumes will almost certainly continue to build rapidly as education and marketing push deeper into the universe of suitable investors, who now have access to more advanced strategies, efficient trading platforms and low-cost execution.