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.


The former can be

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