Quantifying Market Correlation Risk

Gunter Meissner

“The [financial] industry is more technical than ever, and there is as much need to understand the risks of the system as ever”

– Robert Merton

In this chapter we will discuss and quantify the correlation risk of financial products whose primary focus is market risk. Let us just clarify what market risk is. Market risk is the risk of financial loss due to an adverse change in the price of a financial security.

We typically differentiate four main types of markets: (a) the equity market; (b) fixed-income market; (c) commodity market; and (d) foreign-exchange-rate market. However, other markets can be categorised as energy market, real-estate market, weather market, economic variables, etc. A financial security is a tradable asset in one of these markets, such as stocks, bonds, commodities, exchange rates, real estate, or futures, options and swaps on these securities.

THE CORRELATION RISK PARAMETERS CORA AND GORA

In Chapters 3 to 5 we discussed models to quantify the correlations among one or more financial variables. We will now discuss how to quantify correlation risk, ie, the risk that the correlations change. We introduce a correlation risk parameter, which we

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