Correlation Risk Modelling and Management (2nd Edition)
First published:
ISBN: 978-1-78272-405-6
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Quantifying Market Correlation Risk
Introduction
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
“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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