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Much like volatility, correlation varies with time and market conditions. A local correlation model captures the way correlation varies with time and underlying assets’ prices. These models are especially important in the pricing of multi-asset derivatives such as basket options, which typically require the use of the matrix of correlations between the assets. In a local correlation model this matrix is assumed to be state-dependent, or dependent on time and asset prices; many other models assume the matrix to be constant.
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