Correlation Basics: Definitions, Applications and Terminology
Empirical Properties of Correlation: How do Correlations Behave in the Real World?
The Pearson Correlation Model – Work of the Devil?
Cointegration – A Superior Concept to Correlation?
Financial Correlation Modelling – Bottom-up Approaches
Valuing CDOs with the Gaussian Copula – What Went Wrong?
The One-Factor Gaussian Copula Model – Too Simplistic?
Financial Correlation Models – Top-Down Approaches
Stochastic Correlation Models
Quantifying Market Correlation Risk
Quantifying Credit Correlation Risk
Hedging Correlation Risk
Correlation Trading Strategies – Opportunities and Limitations
Credit Value at Risk under Basel III – Too Simplistic?
Basel III and XVAs
Fundamental Review of the Trading Book
The Future of Correlation Modelling
Answers to Questions and Problems in Correlation Risk Modelling and Management
Correlation risk is the risk that the correlation between two or more financial variables changes unfavourably. Correlation risk was highlighted in the global financial crisis in 2007 to 2009, when correlations between many financial variables, such as return correlation between equities, the default correlation between debtors or the default correlation between a debtor and an insurer, increased dramatically. This led to huge unexpected losses for many financial institutions, which in part triggered the global financial crisis.
This book is the first to address financial correlation risk in detail. In Chapter 1, we introduce the basic properties of correlation risk, before we show how correlations behave in the real world in Chapter 2, which contains 45 years of correlation data from 1972 to 2017. In Chapter 3, we discuss the most widely applied correlation approach in finance, the Pearson correlation model, and evaluate if it is a suitable model for finance. Chapter 4 is a new chapter in this second edition, assessing the Nobel-prise-rewarded Cointegration model. We address specific financial correlation measures in Chapter 5 and discuss whether the Copula correlation model