Exotic Derivatives Trading

February 19, 2009

Dispersion

Filed under: Risk Management of Exotic Derivatives — Exotics Trader @ 4:07 pm

Basic Equation Index Variance = Stock_1_Variance×W12 + Stock_2_Variance×W22 + 2×W1×W2×Vol_Stock_1×Vol_Stock_2×Correlation (Stock1, Stock2) Dispersion: Short Index volatility, long single stocks volatility “. Hence the portfolio is short correlation & Long volatility of single stocks” – No pure exposure to correlation.

Can be traded using basket of calls v/s calls on basket, portfolio of variance swaps on the index and single stocks etc. Dispersion trades are widely used to hedge correlation exposures of the exotic books.

The below discussion shows how to obtain pure correlation exposure by making the portfolio vega neutral. A pure exposure to covariance can be obtained by making the portfolio gamma neutral.

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