Fair Value

At the time of writing, little is known about the "fair value" of correlation swaps. 

Owing to the typically large number of underlyings, the popular MC engine with or without local volatility surfaces requires an NxN correlation matrix as additional input parameter. 

 

There are 2 problems with this approach:

1. Practical problem: individual correlation coefficients cannot be implied from listed option markets. 

2. Theoretical problem: even if one could come up with a sensible implied correlation matrix, a meaningfull dynamic replication strategy for the correlation swap payoff would still be missing. 

 

Ongoing research aims to identify the linkages between dispersion trading and the dynamic hedging of correlation swaps, especially when the underlying assets are the constituent stocks of an equity index. This approach exploits the proxy formulas above to rewrite the correlation swap payoff as a function of tradable variance swaps; in this framework the correlation swap becomes a multiasset volatility derivative, rather than a classical multiasset derivative. 

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