Implied basket correlation dynamics

Härdle Wolfgang Karl () and Silyakova Elena ()
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Härdle Wolfgang Karl: Ladislaus von Bortkiewicz Chair of Statistics, Humboldt-Universität zu Berlin, Unter den Linden 6, 10099 Berlin, Germany; and Sim Kee Boon Institute for Financial Economics, Singapore Management University, Administration Building, 81 Victoria Street, 188065, Singapore
Silyakova Elena: Ladislaus von Bortkiewicz Chair of Statistics, Humboldt-Universität zu Berlin, Unter den Linden 6, 10099 Berlin, Germany

Statistics & Risk Modeling, 2016, vol. 33, issue 1-2, 1-20

Abstract: Equity basket correlation can be estimated both using the physical measure from stock prices, and also using the risk neutral measure from option prices. The difference between the two estimates motivates a so-called “dispersion strategy”. We study the performance of this strategy on the German market and propose several profitability improvement schemes based on implied correlation (IC) forecasts. Modelling IC conceals several challenges. Firstly the number of correlation coefficients would grow with the size of the basket. Secondly, IC is not constant over maturities and strikes. Finally, IC changes over time. We reduce the dimensionality of the problem by assuming equicorrelation. The IC surface (ICS) is then approximated from the implied volatilities of stocks and the implied volatility of the basket. To analyze the dynamics of the ICS we employ a dynamic semiparametric factor model.

Keywords: Correlation risk; dimension reduction; dispersion strategy; dynamic factor models (search for similar items in EconPapers)
Date: 2016
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DOI: 10.1515/strm-2014-1176

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