Correlation Swaps

Financial derivatives have created some interesting opportunities that investors are able to capitalize on. Correlation swaps are a type of derivative that allows a certain amount of speculation about risks by the investor. These speculations can be made about commodities, interest rates and exchange rates. During the early 2000’s, correlation swaps were created to counter the effects that exotic lending had on the markets. These exotic derivatives deal with a wide variety of assets that can be complicated to value as a whole. The complex equations that correlation swaps deal with make it difficult to track whether or not they are even making an impact on the markets.

Correlation swaps also allow investors to approach modeling and pricing in a different way. They add a significant amount of variation by letting the investor pay off correlations that underlying assets produce. Correlation swaps are considered OTCs or over-the-counter trading. Both equity and foreign exchange markets that deal with derivatives are involved. The investor can expose specific correlations with exotic investments even though certain changes with these types of investments are unobservable. Correlation swaps have both advantages and disadvantages to investors.

First off, correlation swaps are used for investors to gain clarity with long term investments. A bundle of securities and a certain fixed strike price will reveal whether or not correlation swaps will produce a return. The investor attempts to predict future correlation prices between the realized prices vs. the market prices. The difference between these two can be capitalized on by investors by producing a return. This happens when the underlying stock price turns out to be lower than its strike price. The disadvantage of correlation swaps is that they are dependent on a specific path which makes them difficult to capitalize on.

Variance based trades hold more liquidity when compared to correlation swaps. Even so, correlation swaps typically show a 10 point higher margin of return when exposed. Credit default swaps, also known as CDSs, have a certain amount of risks that are unobservable to the investor. Cracking the correlation swaps that are embedded within these types of investments help investors realize not only the risks, but yield as well. This so called hidden information can be capitalized on by using it as a means of hedging. Smart investors have portfolios that show certain swaps being used as a means of hedging. FRAs, or forward rate agreements, deal with futures and bonds. These futures and bonds can change in value.

The change in value offsets the total value of swaps. This is directly caused by interest rates changing during the life of the investment, particularly investments that deal with futures and bonds. Investors can hedge their portfolio by first analyzing the element of risks. However, hedging does cost the investor some cash so swap portfolios will only be hedged partially. Anytime that an investor looks to reduce risk with their portfolio they will hedge their investments. The cost of hedging must be factored into the total amount of return that the investor will see.

Swap trading is extremely complex and should be handled by experienced investors. The amount of variations that are involved with correlation swaps can only be revealed by using complex mathematical equations. The correlations between certain swaps will differ from each category of the swap market. Interest rate swaps, currency swaps, commodity swaps, equity swaps and credit default swaps all will produce a variety of correlations. The intricacy of swap markets can leave many investors perplexed. Constructing a well thought out plan to gain a return with swap markets by analyzing correlations may take some time getting familiar with.

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