Risk glossary

 

Correlation

A measure of the degree to which changes in two variables are related. Correlation ranges between +1 (perfect correlation – the same amount of movement in the same direction) and -1 (perfect negative correlation – the same amount of movement in opposite directions). Like volatility, it can be calculated from historical data, but such calculations are not necessarily good predictors of behaviour.

If the correlation between markets is known, an option position in one market can be offset against another with similar direction and volatility. This is advantageous, because it can circumvent difficult hedging environments and can reduce costs.

Correlation is also important for the pricing of some options, particularly those offering exposure to more than one market variable. The payout of a spread option or a yield curve option is based on the correlation between

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