NEW YORK, March 15: Credit derivative traders have been piling into certain structured credit trades designed to generate high premium income while also taking a hedge against extreme deterioration of the economy.

As traders rush into the same opportunity though the risk grows that an unexpected event could have them rushing to exit the trade at the same time, creating even more volatile financial market moves and large losses.

Credit derivative players this year have been entering structured credit trades where they buy protection on senior pieces of collateralised debt obligations (CDOs) based on a portfolio of investment grade credits, and selling protection on the riskiest pieces, known as the equity.

Demand for the so-called “correlation trades” last week pushed the correlation of the equity tranches to an all-time high. Some of this retraced this week, possibly due to some investors backing out of the trades.

Correlation is a measure of the likelihood that the companies underlying the deal could all default on their debt at the same time.

Equity tranches in CDOs take the first losses in defaults, with the investments typically wiped out when defaults reach 3.0 per cent of the underlying portfolio.

Meanwhile, senior pieces of CDOs are protected from defaults by all the tranches subordinated to them, and as such only suffer losses in the worst case scenario of mass defaults, which would only be anticipated in a systemic meltdown.

The trade has worked well so far this year, as fears of a deteriorating economic environment has bid up the price of the senior CDO tranches, and the equity portions have not suffered any losses as corporate default rates remain benign, said Mikhail Foux, credit products strategist at Citibank in New York.—Reuters