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erstwhile
Posts: 17
Joined: March 3rd, 2003, 3:18 pm

Replication of VarSwaps in practice

May 15th, 2005, 7:08 pm

Droplet: you can't replicate a correlation swap using the usual array of derivatives we all know and love. In practise i think investment banks just stick it in the book on the premise that it decreases the correlation risk in their books and frees up reserves so they can do more trades.HFs take the other side because they think on average it will make money.At an investment bank where i worked, we once did a S&P vs USD-JPY correlation swap (to decrease quanto risk). The HFs that took the other side got an outrageously good statistical bet, and we were able to sell more structured products!
 
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Droplet
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Joined: June 20th, 2004, 7:42 pm

Replication of VarSwaps in practice

May 15th, 2005, 7:39 pm

Thank you, erstwhile! that's what I was afraid of... I just do not understand why one cannot define the sensitivity of the index (basket) volatility to the average correlation between the stocks in the basket. In the recent paper on Option-Implied Correlations and the Price of Correlation Risk we have shown that about 50% if index (OEX) volaility dynamics is explained by the average implied correlation dynamics... so index vega can be split into 2 parts -> one is good old vega, and the other is correlation sensitivity measure. Then we can dynamically (surely very roughly as usual) replicate correlation... is that right? Thanx, Droplet
 
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erstwhile
Posts: 17
Joined: March 3rd, 2003, 3:18 pm

Replication of VarSwaps in practice

May 16th, 2005, 5:50 am

You can certainly set up dispersion trades to approximate a position in correlation - that trade is as old as the hills! The thing is, you can set the trade up multiple (slightly) different ways: gamma neutral, vega neutral, theta neutral, "vol beta" neutral, etc. From memory (i.e., treat as suspect info!), the theta neutral one may give you the best proxy for correlation. You can backtest option or var swap portfolios to check this out.
 
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jasejia200
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Joined: July 6th, 2006, 12:46 am

Replication of VarSwaps in practice

August 9th, 2006, 1:40 am

Quick question: Is there anywhere I can get started for learning the details of Dispersion trading? I have read the articles on edgartech, but I want to have a clear view of the whole strategy such as how to select stocks and how to hedge vega/gamma/delta
 
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Raver
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Joined: September 6th, 2004, 10:28 am

Replication of VarSwaps in practice

August 9th, 2006, 10:01 am

Getting back to replication a varswap, it gives you a constant vega exposure over all the strikes but what about your theta? A move in the vol can move your way but the theta will eat up all your profits. So you can be right but be wrong in the end, right? Or am I missing something?