Default correlation is an important parameter in the pricing of all leveraged portfolio credit products. Historically, dealers would input single name CDS spreads plus a default correlation assumption into their model to price a single tranche. Today, due to the liquidity and standardisation of index tranches, dealers no longer have to calculate the price of the tranche as it already exists in the market. They can back-out from their models the market ‘implied’ correlation.
Correlation is the parameter which explains why the spread of a single tranche can move even when the average spread of its reference portfolio remains unchanged. Like all derivatives, the price of bespoke and index tranches changes in response to supply and demand. When demand for a certain type of tranche makes the spread tighten more than would be expected given the pattern of the underlying spreads, the market is said to be changing its view of correlation.