Deconstructing correlation

Peter Austing introduces an analytic or semi-analytic valuation of basket options

When markets are stressed, assets become more strongly correlated. Just as there is an implied volatility smile, there is also a correlation smile. However, though it is known to exist, the correlation smile has been largely ignored in multi-asset derivatives pricing for reasons of practicality: there may not be liquid instruments to determine the smile, and even if it is known, practical pricing algorithms taking account of the smile may not exist.

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