IDEAS home Printed from https://ideas.repec.org/p/bbk/bbkefp/0712.html
   My bibliography  Save this paper

Variance Dispersion and Correlation Swaps

Author

Listed:
  • Antoine Jacquier

    (Department of Economics, Mathematics & Statistics, Birkbeck)

  • Saad Slaoui

Abstract

In the recent years, banks have sold structured products such as Worst-of options, Everest and Himalayas, resulting in a short correlation exposure. They have hence become interested in offsetting part of this exposure, namely buying back correlation. Two ways have been proposed for such a strategy : either pure correlation swaps or dispersion trades, taking position in an index option and the opposite position in the components options. These dispersion trades have been traded using calls, puts, straddles, and they now trade variance swaps as well as third generation volatility products, namely gamma swaps and barrier variance swaps. When considering a dispersion trade via variance swaps, one immediately sees that it gives a correlation exposure. But it has empirically been showed that the implied correlation - in such a dispersion trade - was not equal to the strike of a correlation swap with the same maturity. Indeed, the implied correlation tends to be around 10 points higher. The purpose of this paper is to theoretically explain such a spread. In fact, we prove that the P&L of a dispersion trade is equal to the sum of the spread between implied and realised correlation - multiplied by an average variance of the components - and a volatility part. Furthermore, this volatility part is of second order, and, more precisely, is of Volga order. Thus the observed correlation spread can be totally explained by the Volga of the dispersion trade. This result is to be reviewed when considering different weighting schemes for the dispersion trade.

Suggested Citation

  • Antoine Jacquier & Saad Slaoui, 2007. "Variance Dispersion and Correlation Swaps," Birkbeck Working Papers in Economics and Finance 0712, Birkbeck, Department of Economics, Mathematics & Statistics.
  • Handle: RePEc:bbk:bbkefp:0712
    as

    Download full text from publisher

    File URL: http://www.bbk.ac.uk/ems/research/wp/PDF/BWPEF0712.pdf
    File Function: First version, 2007
    Download Restriction: no

    Other versions of this item:

    References listed on IDEAS

    as
    1. Brenner, Menachem & Ou, Ernest Y. & Zhang, Jin E., 2006. "Hedging volatility risk," Journal of Banking & Finance, Elsevier, vol. 30(3), pages 811-821, March.
    Full references (including those not matched with items on IDEAS)

    Citations

    Citations are extracted by the CitEc Project, subscribe to its RSS feed for this item.
    as


    Cited by:

    1. repec:gam:jrisks:v:5:y:2017:i:4:p:61-:d:119375 is not listed on IDEAS
    2. Yuhong Xu, 2014. "Robust valuation and risk measurement under model uncertainty," Papers 1407.8024, arXiv.org.

    More about this item

    JEL classification:

    • E60 - Macroeconomics and Monetary Economics - - Macroeconomic Policy, Macroeconomic Aspects of Public Finance, and General Outlook - - - General
    • C22 - Mathematical and Quantitative Methods - - Single Equation Models; Single Variables - - - Time-Series Models; Dynamic Quantile Regressions; Dynamic Treatment Effect Models; Diffusion Processes

    NEP fields

    This paper has been announced in the following NEP Reports:

    Statistics

    Access and download statistics

    Corrections

    All material on this site has been provided by the respective publishers and authors. You can help correct errors and omissions. When requesting a correction, please mention this item's handle: RePEc:bbk:bbkefp:0712. 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: (). General contact details of provider: http://www.ems.bbk.ac.uk/ .

    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 CitEc recognized a reference but did not link an item in RePEc 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 RePEc Author Service 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.

    IDEAS is a RePEc service hosted by the Research Division of the Federal Reserve Bank of St. Louis . RePEc uses bibliographic data supplied by the respective publishers.