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Note: Correlation trading through swaps enables one to take a purely systematic correlation view. The fixed side of the swap is based on the implied correlation, which is calculated from the related implied volatilities. The floating side is the final realized correlation of spot returns at expiration (typically 4pm London WMR Fix) using the standard Pearson's correlation. Due to the mean reverting nature of correlations and the fact that they have mathematical and natural type boundaries, the product can create excellent trading opportunities. Other attractive features are asset diversification, zero premium outlay, and efficiency relative to the vanilla option replication.
Introduction
Correlation trading through swaps enables one to take a purely systematic correlation view. The fixed side of the swap is based on the implied correlation, which is calculated from the related implied volatilities. The floating side is the final realized correlation of spot returns at expiration (typically 4pm London WMR Fix) using the standard Pearson's correlation. Due to the mean reverting nature of correlations and the fact that they have mathematical and natural type boundaries, the product can create excellent trading opportunities. Other attractive features are asset diversification, zero premium outlay, and efficiency relative to the vanilla option replication.
Correlation Misconceptions
One of the misconceptions of correlation is that it has sensitivity to direction or that it implies causation (estimating the return of one asset based on its correlation to another asset). Correlation is a linear measurement of dependence between returns. In reality, there is nothing directional in the calculation as correlation is entirely dependent on the relationship of the asset's volatilities. Volatility itself may have a directional bias as implied by risk reversals; however correlation is only related to the volatilities in isolation. Since volatility drives correlation, and not direction, it is possible to have diverging assets with positive correlation (and vice versa), which is quite contrary to popular interpretations. For example, between April 2009 and Dec. 2009, both the yen and the Australian dollar steadily...