Unstable correlations

Posted by Izabella Kaminska on Dec 07 11:00.

BNP Paribas looks at the issue of cross-asset correlations on Monday, with some curious results.
First note the following charts, which depict correlations between equities and commodities, currencies and risk instruments (click to enlarge):

http://av.r.ftdata.co.uk/lib/inc/getfile/23516.jpg
As the chart indicates some asset classes have indeed grown to be more correlated than others — commodities and equities, for instance.
Nevertheless, in the opinion of BNP Paribas’ Simon Carter, none of the charts actually reflects a completely stable relationship. As he notes (our emphasis):
Although in some cases at extremes, we highlight that for many assets, correlations vs. equities are unstable, so investors should look for opportunities to take advantage of their fundamental views vs. market conditions using hybrid options or proxy trades. Chart 1 . . . shows commodities, until recently, near historic high correlation vs. equities (S&P 500). This could largely be explained through Chart 2 . . . showing high levels of correlation of equities vs. EURUSD (i.e. USD weakness from being used as a funding currency). The CRB index (non-oil) correlations have fallen off recently, given commodities have rallied in the face of volatile equities.We note the recent fall of USDJPY correlation vs. equities, as JPY use as a funding currency has receded. Chart 3 . . . shows that near-term risk indicators (e.g. VIX and X-over vs. S&P 500) have also been trading at fairly high correlations recently. However longer-dated risk measures such as 12 month equity implied vols and US 10- year bond yields have remain far less correlated with equities. This is probably a function of an unwillingness to take significant risk even as equities rallied: e.g. few aggressive sellers of long-dated volatility, and strong govvie markets fuelled by government intervention.
Which leads him to recommend hedging any correlation-based trades as follows:
* Buying downside protection on equities dependent on the gold prices rising or oil falling. The aim is to reduce the option premium by adding additional contingency to payoffs.* Using credit instruments to hedge equity positions.* Using FX options to hedge equity positions, assuming for example high correlations of EURUSD vs. equities.*Buying upside equity calls contingent on govvies remaining uncorrelated.