Exciting Arbitrage Opportunity
Tue, Dec 15, 2009 | Jared Woodard
From the Wikipedia entry:
A correlation swap is an over-the-counter financial derivative that allows one to speculate on or hedge risks associated with the observed average correlation of a collection of underlying products, where each product has periodically observable prices, as with a commodity, exchange rate, interest rate, or stock index.
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Pricing and valuation
No industry-standard models yet exist that have stochastic correlation and are arbitrage-free.
Quants: get to work. EDIT: Mostly kidding, of course – unless you a) have some kind of affective disorder and b) work for a major bank or fund, this is neither exciting nor an opportunity for real arbitrage.
December 15th, 2009 at 11:41 am
I first wrote on correlation in 1994 in RISK magazine. At that time, there was an arbitrage with single stock volatility being cheap relative to index volatility. Alas, that is no longer true, though I do know some who still trade correlation.
It may sound obscure, but correlation trading helps investors who buy index puts get the best price when there are sellers of single stock options.
December 15th, 2009 at 11:51 am
Michael, I’m aware of and all in favor of correlation trading. It’s the discovery of a standard pricing model for the swap that, while useful and etc., I wouldn’t regard as exciting (in earnest). Maybe I’m too interested in things like poetry and roller coasters; to each his own.