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Basel II and the Risk Management of Basket Options with Time-Varying Correlations

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  • Amy S. K. Wong

    (Tinbergen Institute, Erasmus University Rotterdam)

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    Abstract

    The impact of jumps, regime switches, and linearly changing correlation term structures on the risk management of basket options has been examined in this paper. First, the results show that there is an asymmetric correlation effect on the value-at-risk of basket options. Second, the time at which a correlation shock occurs during the life of an option is particularly important for hedged basket options. Finally, the square-rootof- time rule can lead to severe underestimation of value-at-risk for basket options with time-varying correlations – for some cases, even by a factor exceeding the minimum regulatory stress factor.

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    Bibliographic Info

    Article provided by International Journal of Central Banking in its journal International Journal of Central Banking.

    Volume (Year): 2 (2006)
    Issue (Month): 4 (December)
    Pages:

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    Handle: RePEc:ijc:ijcjou:y:2006:q:4:a:1

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    1. William N.Goetzmann & Lingfeng Li & K.Geert Rouwenhorst, 2003. "Long-Term Global Market Correlations," DNB Staff Reports (discontinued) 98, Netherlands Central Bank.
    2. Jean-Pierre Zigrand & Jon Danielsson, 2003. "On time-scaling of risk and the square–root–of–time rule," FMG Discussion Papers dp439, Financial Markets Group.
    3. Clifford R Dammers & Robert N McCauley, 2006. "Basket weaving: the euromarket experience with basket currency bonds," BIS Quarterly Review, Bank for International Settlements, March.
    4. Philippe Artzner & Freddy Delbaen & Jean-Marc Eber & David Heath, 1999. "Coherent Measures of Risk," Mathematical Finance, Wiley Blackwell, vol. 9(3), pages 203-228.
    5. Francis X. Diebold & Andrew Hickman & Atsushi Inoue & Til Schuermann, 1997. "Converting 1-Day Volatility to h-Day Volatitlity: Scaling by Root-h is Worse Than You Think," Center for Financial Institutions Working Papers 97-34, Wharton School Center for Financial Institutions, University of Pennsylvania.
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