A dynamic model for correlation

Equity markets have experienced a significant increase in correlation during the crisis, resulting in exotic derivatives portfolios realising large losses. As larger correlations in downward scenarios are already implied in the index option market in the form of a correlation skew, the losses could have been alleviated if models had incorporated this information properly. In this article, Alex Langnau generalises the multi-asset version of Dupire’s local volatility model to a ‘local correlation’ model, achieving consistency with both the constituent and index option markets while preserving the efficiency and easy implementation

Most investment banks utilise a Gaussian copula to price multi-asset exotic European-style payouts. For more involved payouts, a multi-asset version of Dupire’s local volatility model has become the market standard for pricing and hedging. The model infers a local spot-dependent volatility surface from option prices for each asset and combines them via a (constant) correlation matrix between its Wiener increments. However, even when correlations are assumed to be time-dependent, the model does

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What gold's rise means for rates, equities

It has been several years since we have seen volatility in gold. An increase in gold volatility can typically be associated with a change in sentiment and investor behavior. The precious metal has surged this year on increased demand for safe haven…

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