Advanced Search
MyIDEAS: Login to save this paper or follow this series

Introduction into "Local Correlation Modelling"

Contents:

Author Info

  • Alex Langnau
Registered author(s):

    Abstract

    In this paper we provide evidence that financial option markets for equity indices give rise to non-trivial dependency structures between its constituents. Thus, if the individual constituent distributions of an equity index are inferred from the single-stock option markets and combined via a Gaussian copula, for example, one fails to explain the steepness of the observed volatility skew of the index. Intuitively, index option prices are encoding higher correlations in cases where the option is particularly sensitive to stress scenarios of the market. As a result, more complex dependency structures emerge than the ones described by Gaussian copulas or (state-independent) linear correlation structures. In this paper we "decode" the index option market and extract this correlation information in order to extend the multi-asset version of Dupire's "local volatility" model by making correlations a dynamic variable of the market. A "local correlation" model (LCM) is introduced for the pricing of multi-asset derivatives. We show how consistency with the index volatility data can be achieved by construction. LCM achieves consistency with both the constituent- and index option markets by construction while preserving the efficiency and easy implementation of Dupire's model.

    Download Info

    If you experience problems downloading a file, check if you have the proper application to view it first. In case of further problems read the IDEAS help page. Note that these files are not on the IDEAS site. Please be patient as the files may be large.
    File URL: http://arxiv.org/pdf/0909.3441
    File Function: Latest version
    Download Restriction: no

    Bibliographic Info

    Paper provided by arXiv.org in its series Papers with number 0909.3441.

    as in new window
    Length:
    Date of creation: Sep 2009
    Date of revision: Sep 2009
    Handle: RePEc:arx:papers:0909.3441

    Contact details of provider:
    Web page: http://arxiv.org/

    Related research

    Keywords:

    This paper has been announced in the following NEP Reports:

    References

    References listed on IDEAS
    Please report citation or reference errors to , or , if you are the registered author of the cited work, log in to your RePEc Author Service profile, click on "citations" and make appropriate adjustments.:
    as in new window
    1. José Fonseca & Martino Grasselli & Claudio Tebaldi, 2007. "Option pricing when correlations are stochastic: an analytical framework," Review of Derivatives Research, Springer, Springer, vol. 10(2), pages 151-180, May.
    Full references (including those not matched with items on IDEAS)

    Citations

    Lists

    This item is not listed on Wikipedia, on a reading list or among the top items on IDEAS.

    Statistics

    Access and download statistics

    Corrections

    When requesting a correction, please mention this item's handle: RePEc:arx:papers:0909.3441. See general information about how to correct material in RePEc.

    For technical questions regarding this item, or to correct its authors, title, abstract, bibliographic or download information, contact: (arXiv administrators).

    If you have authored this item and are not yet registered with RePEc, we encourage you to do it here. This allows to link your profile to this item. It also allows you to accept potential citations to this item that we are uncertain about.

    If references are entirely missing, you can add them using this form.

    If the full references list an item that is present in RePEc, but the system did not link to it, you can help with this form.

    If you know of missing items citing this one, you can help us creating those links by adding the relevant references in the same way as above, for each refering item. If you are a registered author of this item, you may also want to check the "citations" tab in your profile, as there may be some citations waiting for confirmation.

    Please note that corrections may take a couple of weeks to filter through the various RePEc services.