Skewing up correlation:

understanding correlation skew in equity derivatives

Valer Zetocha

Abstract

The goal of this paper is to ll in the gap between the multi-asset equity derivatives market and the mathematical
models developed to treat the correlation skew problem. We analyze the structure of the equity correlation market and
explain which parts are aected by correlation skew. Using a Jacobi instantaneous correlation model as a vehicle to
gain intuition, we approach the issue from both the perspective of historical realized correlation as well as from the
market-implied one. We study the eect of correlation skew on the typical structures traded in the correlation market.
The main result is the calibration procedure for such a model. Once calibrated, the model provides a link between
various correlation derivatives, most importantly between the basket dispersion trades and Worst-Of structures, the two
main vehicles of correlation business.
Keywords: correlation skew, stochastic correlation, Jacobi process, index skew, implied correlation

1. Overview of equity correlation market in the form of equally-weighted at-the-money call vs

Multi-asset equity derivatives are always very popular
alternatives to single-stock ones for the extra squeeze in
price that they bring, as, generally speaking, the multi-
asset options are cheaper. The hunt for high payo while
maintaining a low price situates the typical clients (be it
institutional, retail or private banking) always on the same
side of the trade: they buy the correlation and the banks
sell it. This standard positioning then aects the pricing
of correlation in the inter-dealer broker market (IDB). The
one exception to this are the hedge funds which typically
sell correlation via correlation swaps.
The following are the main parts of correlation deriva-
tives market:
ˆ Index dispersion trades(ID ): vanilla options on the
components of an index vs the option on the index1 .
The typical trade would be a one year SX5E 90%
put dispersion with a notional of ¿50M. Dispersion
trades on main indices usually trade with good liquid-
ity in IDB market. Although the components of the
trade rest with single-stock and index volatility desks,
there is clearly correlation information encoded in the
volatility of the index, hence the possibility of taking
a position in correlation via this trade.
ˆ Basket dispersion trades: vanilla options on a set
of underlying stocks vs option on the whole basket.
This is the work-horse of IDB market, usually trading
1 Before 2008 there were also dispersion trades via variance swaps.
However, the big losses in the volatile days of the deep nancial crisis
made the variance swaps on single stocks unpopular and that aected
the dispersion trades as well.
Email address: vzetocha@yahoo.com (Valer Zetocha)
call (CvC ) for Dec maturities up to 5 years. This is
how the banks recycle the correlation risk (buy the
correlation), as well as put on extra positions. Their
liquidity is related to the liquidity of stocks forming
the basket. The typical notional is ¿50M which, for
a 3 year maturity represents a correlation exposure of
the order of ¿40K per correlation point.
ˆ Worst-Of options(WO ): the typical trades that pro-
vide high leverage for the clients, they are the main
vehicle of the correlation business. Be it by selling the
WO put or by buying the WO call or digital, the client
is always buying correlation via the exposure to WO
forward. WO options also trade in the IDB market,
with or without the Down-and-In barrier, but they
are less frequent and less liquid than CvCs. A typical
trade would be a one year 3-asset at-the-money WO
put with 80% down-and-in barrier and a notional of
¿10M. Such a trade would have correlation sensitivity
of the order of ¿10K per correlation point.
ˆ Correlation Swaps(CS ): pay the realized correla-
tion as measured by the standard Pearson correlation
estimator. Correlation swap is the easiest and lowest-
maintenance form of entering into and running a cor-
relation position. This makes it very popular with
the hedge funds betting on correlation fall. Typically
the hedge funds sell the correlation via swaps. There
can be substantial liquidity for correlation swaps on
SX5E, but the interest in trading CS on bespoke bas-
kets is irregular and can dry completely for long peri-
ods of time. Typical notional is ¿100K per correlation
point.
1 May 25, 2014

Electronic copy available at: http://ssrn.com/abstract=2441724

 SX5E 3M correlation vs return 1Y implied SX5E correlation skew
1 0.8
linear regression -0.38*x+0.53 SX5E implied correl skew
0.75
0.8
0.7

implied correlation
3M correlation

0.6 0.65

0.6
0.4 0.55

0.5
0.2
0.45

0 0.4
-0.4 -0.3 -0.2 -0.1 0 0.1 0.2 0.3 0.4 70 % 80 % 90 % 100 % 110 % 120 % 130 %
3M return strike

Figure 1: 3M realized correlation vs 3M historical log-returns for Figure 2: SX5E implied correlation skew as of 13 Jan 2014.
SX5E from Jan 2009 to Jan 2014

ˆ Miscellaneous trades:
rainbow options, individu-
ally capped baskets, out-performance options, etc, are
all o-shoots of the above trades and can be either
included in the above categories or they represent a
small part of the business.
Taking a naive approach of using models with constant
correlation one arrives at observing three dierent lev-
els of implied correlation traded in the market: correla-
tion swaps (CS) trade at discount to index dispersion (ID)
which trade at discount to worst-of trades (WO). The dif-
ference between ID and CS levels can in large part be
explained by component weights2 , dividends3 and ow4 .
However, that does not apply for WO implied correlation
levels. In this case, as well as in various other miscel-
laneous trades, one needs a stochastic correlation model
that explains the correlation skew.
The rest of the paper is organized as follows. After a
brief description of the correlation skew problem in Sec-
tion 2, we present a model that explains it in Section 3.
Section 4 focuses on calibration while Section 5 describes
an extension of the model to pair-wise non-constant cor-
relation matrix. We nish the paper with an example of a
WO put.
2. Correlation skew
Correlation between stocks is far from constant. How-
ever, what can (and did) hurt correlation books more than
2 CS is equally-weighted while indices are usually capitalization-
weighted. The heavier members of the index tend to be more cor-
related than the less-important ones. Indeed, looking at the last 5
years of data in yearly intervals, the top 20 stocks of SX5E have con-
sistently realized a higher correlation than that of full SX5E index.
The dierence stayed between 1% and 6%. The non-equal weights of
SX5E index then eectively increase the index implied correlation.
This eect can be of the order of 2-3%.
3 CS do not adjust the closing prices for the amount of dividend
on ex-dividend dates. This, together with a random distribution of
ex-dividend dates of members of an index, eectively decreases the
correlation realized by a swap. The eect is of the order of 1%.
4 The client ow in CSs is always in the same direction: hedge
funds sell correlation, so there is a downwards pressure on CS levels.
2
the stochasticity of correlation is the correlation skew: the
tendency of stocks to correlate more when the market falls.
Let us have a look at the problem from two dierent per-
spectives: historical distribution of realized correlation on
one hand and correlation implied by the market on the
other.
2.1. Realized correlation
It has been pointed out repeatedly in the literature that
the correlation rises when the market falls5 . Instead of dis-
playing the co-movement of price and correlation, Figure
1 shows 3M realized correlation for SX5E vs the index 3M
performance. Although loaded with noise, the tendency
of realizing a higher correlation when the market falls ma-
terializes in the negative slope of about -0.4 of the linear
regression line.
2.2. Implied correlation
Correlation skew is best observed in index vanilla op-
tions. The market charges higher implied correlation for
lower strikes, as seen in Figure 2.
Like the volatility skew itself, the correlation skew is
most pronounced at shorter maturities, having a decaying
structure as shown in Figure 3.
3. Modeling stochastic correlation
Various dierent approaches have been developed in re-
cent years along the following lines:
ˆ Local correlation: an umbrella for various approaches
where the correlation depends on stock prices in a
similar fashion to local volatility. See eg, Langnau
(2010), Reghai (2010).
ˆ Non-Gaussian copula: a quick model for products de-
pending on one maturity only. See eg, Lucic (2013).
5 See for example the co-movements of S&P500 index price and
monthly realized correlation exhibited in Boortz (2008)

Electronic copy available at: http://ssrn.com/abstract=2441724

 Term structure of SX5E implied correlation skew Here the correlation coecient is pair-wise constant (no
0.18
correlation skew
dependence on i,j) and follows itself a stochastic process
0.16 of Jacobi type:
0.14
(2)
p
dρt = α(ρ̄ − ρt )dt + β (1 − ρt )(ρt − ρmin )dW̃t
correlation skew

0.12

For suitable coecients this process is bounded between

0.1

(ρmin , 1). The process mean-reverts with a rate of α to its

0.08

0.06
long-term solution, ρ̄, and it has a volatility coecient of
0.04
β . The process starts at ρ0 .
0.02
The Wiener process Ŵ t which drives the instantaneous
0
0 1 2 3 4 5 6 correlation is itself correlated with the rest of Brownian
maturity (years) drivers:
Figure 3: Term structure of SX5E implied correlation skew dened < dŴt , dWt‘j >= ρCS δ(t − t‘)
as the dierence in implied correlation for strikes 90% / 100%. As
of 13 Jan 13. The constant correlation-stock correlation, ρCS , brings
to ve the number of parameters of the model. The cor-
ˆ : usually
Stochastic instantaneous correlation models relation skew eect appears when ρCS is set to a negative
based on Jacobi process as in van Emmerich (2006), number.
Ahdida and Alfonsi (2012). The correlation matrix for N+1 processes then looks as
follows:
ˆ Variance-covariance models : based on Wishart  
1 ρt ρt · · · ρt ρCS
stochastic process, see for example Da Fonseca (2006)  1 ρt · · · ρt ρCS 
: exten-
 
ˆ 1 ··· ··· ···
Common jump and/or market factor models
(3)
 
sions of Merton model to multi-asset settings with
 
 1 ρt ρCS 
common jumps whose sizes are correlated negatively
 
 1 ρCS 
with the brownian motions driving the stocks.6 1

For the purpose of the current paper we need a model
that has the ability to match the market prices and that
is consistent with historical distributions. We would also
welcome intuitiveness and calibrability, and it would be a
great advantage if the model were robust and quick. The
next section explains a model we believe satises our re-
quirements.
3.1. The model
The model we shall use is based on a Jacobi process for
instantaneous correlation7 .
We set the model within a N-asset local volatility frame-
work. Each stock follows a process of type8
dSti
= rdt + σ i (St , t)dWti
Sti
The minimal correlation that can be input in the above
matrix while still preserving the positive semi-deniteness
is ρmin and denes the left boundary for the Jacobi process
(2). A simple computation shows that ρmin is dependent
on the number of stocks N and ρCS :
−1 + N · ρ2CS
ρmin = (4)
N −1
The fact that the upper left N×N sub-matrix of (3) is
pair-wise constant makes the Choleski decomposition a lin-
ear operation. In fact the step of correlating the Brownian
increments in the Monte Carlo simulation can be made
so ecient that it requires just a minimal extra compu-
tational time. This proves crucial in implementing the
model, as the running time is indeed a make-or-break is-
(1) sue.

where σti (St , t) is the local volatility and Wti are the stan- 3.2. Properties
dard Wiener processes correlated as follows: The model has a number of properties that will prove
very useful when we calibrate it. The following results are
< dWti , dWt‘j >= ρt δ(t − t‘) based on van Emmerich (2006), Delbaen and Shirakawa
(2002).
6 The author is not aware of any publication that would address 1. Moments are analytically tractable. In particular, the
directly the correlation skew using common jumps. mean and variance are easily computable as follows:
7 For more details on Jacobi processes see eg, van Emmerich
(2006), Delbaen and Shirakawa (2002). E[ρT ] = ρ̄ + (ρ0 − ρ̄)e−αT (5)
8 For simplicity we suppress dividends. They can be added in a
straight-forward manner. V ar[ρT ] = U1 + U2 + U3 − E[ρT ]2 (6)
3
 where the U -terms are dened as follows: Term structure of expected value of average realized correlation

β2 0.8
α = 0.5
U1 = (ρ̄ − ρmin )(1. − ρ̄) + ρ̄2 α = 1.0
2α + β 2 0.75 α = 5.0

ρ0 − ρ̄  2
β (ρmin + 1.) + 2αρ̄ e−αT

U2 =

correlation mean
0.7
α+β 2

0.65
1 n 2α(ρ − ρ̄) 
0
U3 = 2
α(ρ0 − ρ̄) 0.6
2α + β α + β2
1 0.55
−β 2 ( (ρmin + 1.) − ρ0 )

2 o 2 0.5
−β 2 (ρ0 − ρmin )(1. − ρ0 )) e−(2α+β )T 0 0.5 1 1.5 2 2.5 3 3.5 4 4.5 5
maturity

2. In practice we are more interested in the average re-

alized correlation to some maturity T, which is the Figure 4: Term structure of expected future realized correlation ΥT
for ρ0 = 0.8 and ρ̄ = 0.5 and dierent values of mean reversion rate
continuous-time limit of a correlation swap: α
ˆ T
1
ΥT = ρt d t (7)
T 0 3.3. Intuition
For this quantity, the mean and variance are also an- To gain some intuition we take a look at statistical prop-
alytical and can be computed in a straight-forward erties of the distribution of stochastic correlation given by
manner: the model. Our main interest lies in average correlation to
1 − e−αT time T , ΥT dened in (7) , as that is the relevant quantity
E[ΥT ] = ρ̄ + (ρ0 − ρ̄) (8) for multi-asset derivatives.
αT
2 B Figure 4 shows the expected value of average realized
V ar[ΥT ] = 2 (A1 + A2 + A3 + ) − E[ΥT ]2 (9) correlation as a function of maturity for ρ0 = 0.8 and
T 2
ρ̄ = 0.5 and dierent values of mean reversion rate α. The
Here the A, B terms are dened as follows: remaining two parameters, volatility β and correlation-
(αT + e−αT − 1)  2 β 2 (ρ̄ − ρmin )(1. − ρ̄)  stock correlation, ρCS , do not aect the rst moment of
A1 = ρ̄ +
α2 2α + β 2 ΥT .
As we can see, the mean of ΥT starts at initial correla-
A2 = −
(ρ0 − ρ̄)  2
β (ρmin + 1.) + 2αρ̄
 tion ρ0 and tends to long-term correlation ρ̄ at large ma-
(α + β 2 ) turities, following an exponential curve that drops faster
1 the higher the rate of mean reversion.
× 2 (αT e−αT + e−αT − 1)
α Figure 5 shows the standard deviation (St.Dev) of aver-
age realized correlation to time T, ΥT , for various values
of . The volatility of correlation, β , has been chosen to
1 n 2α(ρ − ρ̄)
A3 = −
0 α
(2α + β 2 )(α + β 2 ) (α + β 2 ) match the upper boundary of the Feller condition. This
1 way it maximizes the standard deviation of ΥT .
× α(ρ0 − ρ̄) − β 2 ( (ρmin + 1.) − ρ0 )
 
2 Basic intuition is gained directly from the SDE formula
of Jacobi process:
o
2
−β (ρ − ρ )(1. − ρ )
0 min 0

h e−αT − 1 (e−(2α+β 2 )T − 1) i ˆ ρ0 is the starting level of correlation

× −
α 2α + β 2 ˆ ρ̄ is the level to which the process tends. The closer
this level to the boundaries, either ρmin or 1, the less
ρ̄ h ρ̄α2 T 2 room it will have to move, and hence the smaller St.
B = 2 + (αT + e−αT − 1)(ρ0 − 2ρ̄)
α2 2 i Dev. can be achieved.
+(ρ0 − ρ̄)(αT e−αT + e−αT − 1)
ˆ α is the speed of mean-reversion. The bigger alpha
3. The boundaries of the instantaneous correlation, ρmin the quicker the correlation is pulled towards the long-
and 1, are unattainable provided the following condi- term level ρ̄.
tions are met:
2α 1 − ρmin 2α 1 − ρmin ˆ β is the volatility of instantaneous correlation. The
≥ && ≥ (10) bigger the β the larger the St.Dev. of ΥT . It is
β2 ρ̄ − ρmin β2 1 − ρ̄
bounded from above by the Feller condition.
These inequalities are the equivalent of the Feller condition
for the Heston model. In a slight abuse of language we shall ˆ ρCS is the correlation between the stocks and the cor-
refer to them as the Feller condition. relation itself and it determines the correlation skew.
4
 St.Dev. of average correlation vs maturity T
0.2
St.Dev. of average correlation to T
0.15
0.1
0.05
0 ρ̄.
0 2
Figure 5: St.Dev. of average correlation vs maturity for dierent
model parameters.
Setting it to zero would mean 'turning o' the corre-
lation skew.
Having developed some basic intuition about the model let
us see how it performs against the historical distribution
of correlation as well as the implied correlation market.
4. Model calibration
Independently of the model used to account for corre-
lation skew, the most challenging part is the calibration.
Compared to the single stock universe of models, in the
multi-stock setup the diculty is two-sided: a computa-
tionally heavy load and the sparsity of market data. In-
deed it is practically infeasible to run on-the-y calibra-
tion based on a Monte Carlo simulation. Equally it is
very unlikely to nd market data on correlation skew for
a random basket. Therefore the calibration of the model
has to be done externally on a periodic basis for a set of
stocks belonging to the same group9 and sharing similar
characteristics.
In light of these diculties we will outline now how to
perform the calibration of the model. Intuitively it is clear
that there are three elements that we need to calibrate:
the level, volatility and skew of correlation. We will deal
with each of them in a separate subsection.
4.1. Level of correlation
To obtain the level of correlation one needs to nd a
liquid and consistent source for pure correlation trades,
without any eect of skew. At-the-money basket disper-
sion trades quoted in IDB in the form of CvCs represent
the ideal source of this information. Given the character-
istics of the business10 , there is a clear and consistent way
the IDB market quotes dierent baskets. Once the quot-
ing system is understood, it is straight-forward to infer
9 Typically the group is formed by stocks belonging to the same
geographical region, index or sector.
10 Banks are mostly selling correlation.
Maturity (months) SX5E St.Dev. Pearson St.Dev.
alpha 0.5, beta 0.69 3 10.74% 4.7%
alpha 1, beta 0.97
12 7.99% 2.3%
alpha 5, beta 2.19
24 7.18% 1.7%
36 5.97% 1.4%
Table 1: Term structure of St.Dev. of SX5E realized correlation and
Pearson coecient for 50 stocks.
correlation for any basket. This information xes ρ0 and
4 6 8 10
Maturity T(yrs)
4.2. Volatility of correlation
There is no liquid market for pure volatility of correla-
tion. Attempts to start quoting options on realized cor-
relation as well as correlation swaptions surfaced in the
years just before 2008 crisis, but even then there was no
real liquidity to be able to calibrate a model. However,
volatility of correlation aects the magnitude of the skew
eect as one can see directly from the SDE of Jacobi pro-
cess equation (2). Setting β = 0 would surely eliminate
any skew eect. Hence one has to look at skew trades and
disentangle both correlation skew and correlation volatil-
ity information from them. Since out-of-the-money CvCs
are infrequent in the IDB market, one has to analyze the
index dispersion trades. We leave this for the next sub-
section and instead we focus here on the historical dis-
tribution of realized correlation, which does provide some
clues on the volatility and the strength of mean-reversion
of correlation.
The key to relating the model to historical realized cor-
relation is the term structure of St.Dev. We compute the
historical St.Dev. of correlation from a set of 10 years of
daily observations of SX5E components. For each matu-
rity T ∈ (3M, 36M ) we take a running window of length
T and compute the daily realized correlation of the SX5E
members. This way we obtain a set of realized correla-
tions that have some mean and some St.Dev. for each
T . The shape of the dependence of St.Dev. on T gives
clues on how strongly the correlation reverts to the mean.
The magnitude of St.Dev. on the other hand tells us how
volatile the correlation is.
In the remainder of this subsection we will use the analy-
sis of St.Dev. of historical correlation to determine reason-
able values for the speed of mean reversion α. However, we
will not use historical distribution to infer β . Instead we
will extract that information from the implied correlation
market, together with ρSC .
The second column in Table 1 shows the standard devi-
ation of SX5E historical realized correlation as described
above. However, this data is not directly comparable to
the St.Dev. of ΥT dened in equation (7). The reason for
that is the fact that the standard correlation estimator,
the Pearson product-moment correlation coecient, is it-
self a stochastic variable with some St.Dev. that depends
5
 Term structure of St.Dev. of correlation: SX5E historical vs model Maturity (months) Mean St.Dev
SX5E historical BBVA.MC / LVMH.PA (10Y data)
3 59.5% 15.4%
0.14
alpha = 1, beta = 0.68
alpha = 5, beta = 1.47
0.12 alpha = 10, beta = 2.1
12 60.6% 9.7%
24 61.5% 7.1%
St.Dev. of correlation

0.1

0.08 36 62.5% 6.2%

BBVA.MC / IBE.MC (5Y data)
3 79.6% 8.8%
0.06

0.04
12 78.0% 9.2%
0.02
24 79.8% 6.0%
0
0 0.5 1 1.5 2 2.5 3
36 79.3% 5.3%
maturity (years)
Table 2: Correlation mean and St.Dev. of various pairs of stocks for
running time window of 3M to 3Y. Computed from 10Y and 5Y of
Figure 6: Term structure of St.Dev. of correlation computed from data as indicated.
historical SX5E correlation vs model results for various values of
mean-reversion speed α. β has been chosen to match the magnitude
of St.Dev. of SX5E historical correlation. For completeness, we used lower volatility of correlation.
ρ0 = ρ̄ = 0.5, ρCS = −0.5 and N = 50. The historical correlation is
based on last 10 years of data.
4.3. Correlation skew

on the number of stocks and maturity11 . For example, the
St.Dev. of Pearson coecient for 50 stocks and a corre-
lation of 50% is displayed in the third column of Table
1.
As a result, to compare the model with the historical
distribution, one has to adjust the variance obtained from
the model by the variance of Pearson for the same maturity
and number of stocks.12
Figure 6 shows the St.Dev. of SX5E historical correla-
tion along with the results of the model for various values
of α, adjusted for the above-mentioned eect. Unlike in
Figure 5, we chose β such that the magnitude of St.Dev.
given by the model matches the historical one.
One important characteristic worth pointing out from
the start is the downward-sloping shape of the function:
the St.Dev. decreases with the increase in measurement
window 13 . It is obvious from the graph that one needs
α of the order of 5 to obtain a shape comparable to the
historical term structure. That means that the correlation
has high volatility14 and it is pulled towards the mean with
a time scale of the order of 3 months.
As we see from Table 2, decreasing St.Dev. with time
is generally true for pairs of individual stocks. As ex-
pected, stocks with correlation close to the limits have
11 In other words, measuring a correlation swap in a Monte Carlo
simulation would have some non-zero distribution width even for
constant correlation.
12 We do this by computing the variance of a correlation swap given
by the Jacobi model via a full Monte Carlo simulation. However, the
simple addition of variances works surprisingly well too.
13 This is a common feature to all of the mean-reverting processes
with a stable limit distribution. The same would hold for St.Dev. of
variance swaps for example, but not for the average of a stock price.
That would mean that the straddles on correlation and on variance
would have decreasing price with increasing maturity. As a contrast
this is clearly not the case for asian options on a stock.
14 but not as high as to reach the limit imposed by the Feller con-
dition.
6
As we have already seen in section 2.2, index options do
have correlation skew priced in. Let us have a look how
the model compares with this market.
Figures 7 and 8 show the volatility skew of SX5E as of
15 Jan 2013 for 3M and 1Y maturity. We also plotted the
skew one would obtain with constant ATM correlation as
well as the one predicted by the model with ρCS = −0.5%,
α = 5 and maximum volatility of correlation allowed by
the Feller condition. We can see that constant correlation
accounts for just a fraction of the full volatility skew. The
model matches quite well the upside volatilities; however,
it comes short of bridging the full gap at low strikes, es-
pecially at very short maturities. It is our belief that the
short-term skew can not be matched completely without
the involvement of jumps15 .
One interesting point to make is that the market im-
plies a much higher volatility of correlation than we see
in the historical distribution. In fact one needs to take
the maximum β allowed by Feller's condition in order to
come close to the market-implied skew. This is a very im-
portant point, which we will use in setting the calibration
guidelines of the model.
Although falling short of completely explaining the
short-term skew, we consider the model to satisfy our
needs as the typical trades range from 1Y to 5Y.
Calibration guidelines
The analysis of the previous subsections brought us to
the following guidelines for calibrating the model:
ˆ the level of correlation, ρ0 and ρ̄, should be obtained
from IDB CvC quotations
ˆ α should be set to 5
15 The problem of short-term skew is similar in nature to the one
experienced in the Heston model.
 SX5E 3M skew: market vs constant correlation vs model matrix. The key to the extension is the linear perturbation
0.26
market
of a correlation matrix16 dened as follows.
0.24
constant correlation
model
Let us consider a N × N correlation matrix M and let us
0.22 denote by Ωmax , Ωmin the pair-wise constant correlation
index implied volatility

0.2
matrices with maximum and minimum average correla-
tion:
0.18
 
0.16 1 1 1 ··· 1
0.14

 1 1 ··· 1 

Ωmax = 1 ··· 1 
0.12
 
 ··· 1 
0.1 1
70 % 80 % 90 % 100 % 110 % 120 % 130 %
strike  
1 ρmin ρmin ··· ρmin
Figure 7: 3M SX5E volatility skew compared to the model with  1 ρmin ··· ρmin 
constant and stochastic correlation. The model parameters were Ωmin

= 1 ··· ···

ρ0 = ρ̄ = 0.45, ρCS = −0.5, α = 5, β = 1.66, with a St.Dev. of

 
correlation of 10.2%
 ··· ρmin 
1
SX5E 1Y skew: market vs constant correlation vs model
0.24 where ρmin is dened in (4). For any 0 ≤  ≤ 1 the
market
constant correlation following perturbations of the matrix M are also positive
0.22 model
semi-denite matrices whose average correlation has been
increased/decreased:
index implied volatility

0.2

0.18
M+ = M + (Ωmax − M ) (11)
M− = M + (Ωmin − M ) (12)
0.16

Varying  we can cover a whole set of matrices that have

0.14
the same texture17 as the original matrix M but whose
0.12 average varies between ρmin and 1.
70 % 80 % 90 % 100 %
strike
110 % 120 % 130 %
We can therefore simulate with a Jacobi process the av-
erage correlation while using the corresponding -shifted
Figure 8: 1Y SX5E volatility skew compared to the model with matrix M+ ,M− with the same average correlation to cor-
constant and stochastic correlation. The model parameters were relate the asset Wiener processes18 . Figure 9 illustrates the
ρ0 = ρ̄ = 0.57, ρCS = −0.5, α = 5, β = 2.05, with a St.Dev. of idea.
correlation of 13.5%
A precomputation of Choleski decomposition for a grid
of -shifted matrices would speed up the Monte Carlo sim-
ˆ ρCS should be in the range (-50%,-60%) ulation to acceptable running time.
ˆ β should be set to maximum allowed by the Feller
condition 6. Example: Worst-Of options

Let us now briey show the impact of correlation skew

5. Further improvements of the model
For the scope of this paper we limited ourselves to
the case of pair-wise constant asset-asset correlation sub-
matrix in (3). This restriction of the model does not aect
its suitability for pricing, as one can compute the price of
an option without the stochastic correlation and then add
its eect as a correction. However, for deal booking and
management, the situation is more demanding: in later
stages of the life of a trade, some pairs might become more
important than others and using a simple average corre-
lation for all pairs would be highly inaccurate. Therefore,
for booking and hedging purposes, one needs a correlation
matrix with full pair-wise structure.
There is a simple and ecient way to extend the model
to contain the full pair-wise structure of the correlation
7
on Worst-Of options. The sign of the eect becomes clear
from the following scenario analysis.
Let us suppose we are long the WO put and hence short
correlation. If the market goes down, the WO put becomes
more in-the-money and hence we will be shorter correla-
tion at a time when it spikes up. In the opposite scenario,
16 This is a well-known tool long used by correlation desks to per-
turb correlation matrices. It has been used for a similar purpose by
Langnau (2010) .
17 By texture of a correlation matrix we mean the order of ele-
ments if ordered by value. Preserving the texture means that pairs
with higher correlation relative to other pairs keep having higher
correlation.
18 It remains an unproven conjecture at this point that the full
(N + 1) × (N + 1) correlation matrix that includes ρCS remains
positive semi-denite.
 M
positive shift
negative
shift M -e M+e

maturity strike price change avg. correl. shift

ρ
min
ρ
ave
ρt 100% 1Y 100% -0.62% 6.7 %
90% -0.61% 9.3 %
stochastic correlation 80% -0.46% 11.6 %
2Y 100% -0.78% 6.3 %
90% -0.81% 8.5 %
80% -0.73% 11.2 %
Figure 9: Correlation space with the extreme pair-wise constant cor- 3Y 100% -0.78% 5.5 %
relation matrices ρmin and 100%. One can associate the stochastic 90% -0.82% 6.9 %
correlation variable ρt with a shifted matrix M+/− whose average 80% -0.78% 8.6 %
correlation is equal to ρt and use this shifted fully textured matrix
to correlate the stocks.
Table 4: Eect of correlation skew on a price of WO put. The last
maturity St.Dev. of correlation column shows the equivalent average correlation shift that produces
the same change in price.
1Y 17.0%
2Y 17.0%
3Y 16.6% rectly aected by correlation skew. Using a Jacobi-based
stochastic instantaneous correlation model, we have linked
Table 3: St.Dev. of correlation as given by the model for the example the prices of baskets and WO structures, providing a cali-
of WO put. The term structure is not decreasing as one would expect bration scheme. Although the calibration is based entirely
because the level of correlation used was dierent for every maturity
(increasing with time), consistent with the levels seen in IDB CvCs. on the option market, the paper also provides a parallel
perspective, that of historical realized correlation. The key
to deciphering the properties of historical correlation is the
when the market goes up, the correlation does go down standard deviation term structure of realized correlation.
but the put will be out-of-the-money and our sensitivity
to correlation decreases. So in one case the skew hurts us Disclaimer
and in the other we don't benet. By denition this is Any views or opinions presented in this paper are solely
a wrong position to hold and a trader should pay less to those of the author and do not necessarily represent those
enter into it. In other words the WO put is cheaper when of the author's employer.
the correlation skew is taken into account. The same hap-
pens to the WO call, as one can easily see by repeating
this type of scenario analysis19 . References
Table 4 shows the eect of correlation skew on a WO
[1] Boortz C.K. (2008), Modelling
put on 3 stocks (ROG.VX, UHR.VX, CSGN.VX) for vari- Correlation Risk, Diplomarbeit in
ous maturities and strikes. The St.Dev. of the correlation, Mathematik
given in Table 3, was kept at maximum, in line with the [2] Langnau A. (2010), A dynamic
above guidelines. It is clear that the eect of correlation model for correlation, Risk April,
pages 74-78
skew is non-negligible. In terms of equivalent correlation [3] Reghai A. (2010), Breaking corre-
shift, the eect can easily cross the bid-oer spread of cor- lation breaks, Risk October, pages
relation20 . Another important point is that the equivalent 90-95
shift in correlation is not constant across strikes, hence any [4] van Emmerich C. (2006), Mod-
elling Correlation as a Stochas-
naive approach of shifting the correlation when pricing a tic Process, Bergische Universitat
WO put will not work. Wuppertal
A similar picture governs the WO call, while for the [5] Ahdida A. and Alfonsi A. (2012),
WO digital the eect depends on the strike: the out-of- A Mean-Reverting SDE on Corre-
lation Matrices
the-money digital decreases in value with correlation skew [6] Delbaen F. and Shirakawa H.
while the in-the-money one increases21 . (2002): An Interest Rate Model
with Upper and Lower Bounds
[7] Lucic V. (2013), Correlation
7. Conclusions Skew via Product Copula, Global
Derivatives conference, Amster-
We have explained the structure of the correlation dam
derivatives market and highlighted the parts that are di- [8] Da Fonseca J., Grasselli M.
and Tebaldi C. (2006), Op-
tion Pricing When Correlations
19 For the sake of completeness, the opposite is true for Best-Of
are Stochastic: An Analytical
options: they become more expensive with correlation skew. Framework . Available at SSRN:
20 The correlation bid/ask spread in IDB CvCs is typically of the
http://ssrn.com/abstract=982183
order of 6-8 correlation points, depending on maturity.
21 This becomes clear when one considers the digital put/call par-
ity.
8