Former Deutsche Derivatives Executive Starts Correlation Fund

By Tom Cahill and Jeff Kearns

Sept. 21 (Bloomberg) -- Chris Craig-Wood, formerly Deutsche Bank AG’s head of equity-index trading, plans a fund he said will be the first dedicated to equity-index correlation, or the degree stocks and indexes move in tandem.

Craig-Wood, who left Deutsche Bank in May for Luxembourg Financial Group, a structured-products firm that manages about $2.5 billion, targets annual returns of 15 percent after fees and costs with the LFG Equity Correlation Fund. LFG plans to start the Luxembourg-listed fund with about 100 million euros ($147 million) and aims to raise as much as $250 million.

Investors who bet that correlation will increase benefit when stocks move in tandem, while those who wager on a decrease profit when stock moves have little in common. Correlation between major equity indexes surged earlier this year as markets plummeted, reaching a record on March 20, according to the Chicago Board Options Exchange S&P 500 Implied Correlation Index.

“Ten years ago people started to look at the VIX -- correlation is the next generation of indicators that can be used to understand the market,” Craig-Wood said in an interview at Luxembourg Financial Group’s offices behind London’s Royal Exchange. “Correlation has become an asset class of its own, with multiple ways to trade it.”

Correlation describes the degree to which prices move in the same direction. Global events affecting markets, such as the Sept. 11, 2001, terrorist attacks or the failure of Lehman Brothers Holdings Inc., can lead to an increase in correlation.

Market Tool

Craig-Wood said equity-index correlation, now traded mostly by securities firm derivative desks, is becoming an increasingly common market tool. CBOE, the biggest U.S. options market, introduced the index in July to track correlation for the Standard & Poor’s 500 Index. The gauge is similar to the exchange’s VIX index, the benchmark index for U.S. stock options and a measure of expected price swings.

The most common method used to trade correlation is a so- called dispersion trade, according to Carl Mason, head of U.S. equity-derivatives strategy at BNP Paribas SA in New York. The strategy involves selling options on a stock index while buying options on the companies in the index, either using individual options or over-the-counter derivative contracts as variance swaps, which are valued based on the volatility of an underlying index or security, he said.

Investors also use OTC derivatives to trade correlation itself, using correlation swaps, which settle based on the amount of actual correlation during a given period.

Options are derivatives that give the right, though not the obligation, to buy or sell a security at a set price and date. Investors use options to guard against fluctuations in the price of securities they own, speculate on share-price moves or bet that volatility, or stock swings, will increase or decrease.

‘Favorable Returns’

“Equity correlation has delivered favorable returns for investors who can manage the complexity of the strategy,” said Dean Curnutt, president of Macro Risk Advisors LLC, a New York- based firm that advises institutional investors on derivatives strategy. “The main source of excess return in the strategy likely results from the premium that investors pay to hedge overall market risk through index put options.”

Craig-Wood, 37, has 15 years of equity-derivatives experience, the last 10 trading at Deutsche Bank. At Luxembourg Financial, he joined a number of fellow Deutsche Bank veterans, including Johan Groothaert, who ran equity-structured products for Deutsche Bank’s equity-markets division. Deutsche ranked No. 2 in derivatives for 2008, according to Risk magazine.

“It’s opening up a new niche that isn’t over-populated,” said Gerald Pittner, 38, a partner at Luxembourg Financial.

To contact the reporter on this story: Tom Cahill in London at tcahill@bloomberg.netJeff Kearns in New York at jkearns3@bloomberg.net