Hedging Correlation Risk

Gunter Meissner

“Only if it was possible to delta-hedge correlation risk … would it make sense to use a full-blown stochastic correlation model”

– Lorenzo Bergomi

In this chapter, we will discuss why hedging financial correlation risk is more challenging than hedging other financial risks such as market risk and credit risk. However, we will show two methods that can be applied to hedge financial correlation risk. At the end of the chapter, we will discuss in which situations it is better to hedge with options and in which it is better to hedge with futures.

WHAT IS HEDGING?

Let us first clarify what hedging is. Hedging is entering into a second trade to reduce the risk of an original trade. If the original trade is a simple transaction such as being long a bond, there are three main ways to hedge the market risk (risk of an unfavourable change in the price) and the credit risk (migration risk and default risk; see Figure 11.1 in the previous chapter). Let us assume an investor had bought a Greek government bond. To hedge the risk, they can perform one of the following.

  1. Simply sell the bond. This is beneficial since all types of risk, such as market risk, credit risk, operational

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