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I keep meeting people who believe they understand correlation. And I keep meeting more people who prove that they don’t. If you trade a correlation swap following the standard market practice, the correlation between two assets is calculated based on the continuous (or log-) returns. I have recently asked a trick question on the MathFinance Conference what would be the correlation of two underlyings asset 1 and asset 2, where the time series of four observed prices are as follows:
Asset 1: 120, 130, 140, 150
Asset 2: 80, 70, 60, 50
The question is that if you know this is going to happen with the two assets will you go long or short prevailing correlation, and if so what is your fair correlation for a zero-cost correlation swap?
The answer is stunning:
Correlation of prices: -100%
Correlation of relative returns: 99.2%
Correlation of continuous returns: 99.1%
Correlation of absolute returns: undefined
The correlation that trades in a standard correlation swap is the one using continuous returns, and it turns out that the two assets are nearly perfectly positively correlated although one goes up and the other goes down. So watch out what you are doing when trading correlation.
I would like to thank Rolf Poulsen for posting back a spreadsheet with my example and a few extensions: UwesCorrelationExample.xlsx
Managing Director of MathFinance
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The ARPM Bootcamp provides in-depth understanding of buy-side modeling from the foundations to the latest advanced statistical and optimization techniques, in nine intense, heavily quantitative hours each day, with theory, live simulations, review sessions and exercises.
Topics include portfolio construction, factor modeling, copulas, liquidity, risk modeling, and much more.
Also features Gala Dinner with world-renowned speakers such as Rob Almgren, Peter Carr, Bruno Dupire, Jim Gatheral, Bob Litterman, Bob Litzenberger, Fabio Mercurio, Steven Shreve.
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The conference will take place between the 15th and 18th December 2015 at the Hilton Hotel. The event will bring together leading experts in Quantitative Finance Industry and Academia in Sydney Australia.
Pensions, Insurance, Regulation, Model Risk, CVA, Risk Measurement, Commodities, Emissions Trading and other areas of Quantitative Finance
PLENARY SPEAKERS INCLUDE
Hansjoerg Albrecher, Alexandre Antonov, Francesca Biagini, Rama Cont, Mark Davis, Freddy Delbaen, Ernst Eberlein, Robert Elliott, Paul Embrechts, Hélyette Geman, Martino Grasselli, Paolo Guasoni, Xin Guo, Constantinos Kardaras, Steve Kou, Dilip Madan, Marek Musiela, Shige Peng, Johannes Ruf, Klaus Sandmann, Michael Schmutz, Stefan Tappe, Dirk Tasche, Xun Yu Zhou
The abstract submission is open until 1st May 2015!
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Please note that Early Bird end on 15 September 2015!
London: 11th - 13th May 2015
New York: 15th - 17th June 2015
Strategic ALM can significantly improve financial performance by delivering a better balance between returns and risks across a more comprehensive set of both on- and off-balance sheet assets and liabilities.
This advanced programme covers best practice in Asset-Liability Management (ALM), as well as ALM’s role as a strategic function in financial institutions.
Practical application and strategic decision making is emphasised via group facilitated discussions, exercises, and case studies.
Presented By: William Blair Santos Allen
London: 14th - 15th May 2015
New York: 18th - 19th June 2015
A two-day course covering the challenges and opportunities arising from the new regulatory changes from Basel III as well as other major European, U.S., and other country regulatory pronouncements, and their implications for management of bank financial institutions.
The programme covers best practices for regulatory capital management in key areas such as: Credit and Market Risk Weighted Capital, Operational Risk Capital, Liquidity Risk, Counterparty Risks, Concentration Risks, Risk Aggregation / Capital Allocation and Stress Testing.
Presented By: William Blair Santos Allen
London: 18th - 20th May 2015
New York: 10th - 12th June 2015
Sydney: 24th - 26th June 2015
This programme covers the latest trends in quantitative modelling for asset allocation and portfolio construction, using new approaches that move away from static asset class investing to a dynamic process considering risk factors and regime changes.
Innovations suggested over the last ten years are contrasted with current industry practice and illustrated with examples with an eye for practical implementation.
New York: 27th - 28th May 2015
The market for index-linked bonds and inflation derivatives has grown rapidly in recent years. This programme covers the mechanics of the instruments, their valuation and how they can be used to take or hedge inflation exposure alone or embedded in other structures.
Presented By: Dr. David Cox
New York: 8th - 10th June 2015
This course provides practical focus on coverage of the management techniques for treasury activities in financial, corporate, and government institutions. Despite organisational differences, treasuries in these various types of institutions share important similarities related to the identification, measurement, and management of risks related to cash flows, fair valuation and counterparty credit.
Practical sessions introduce frameworks for identifying and measuring these risks and evolves into selected numerical techniques using Excel for optimal risk management. Analytical numerical techniques are practiced through Excel with add-ins developed specifically for these applications. All math and statistical concepts are taught through practical applications in Excel, thus avoiding complex theoretical notations and formulas.
New York: 15th - 16th June 2015
The programme aims to provide a sound understanding of the up-to-date practical realities of trading and risk managing correlation, especially equity and equity/forex. The course will draw heavily from recent markets case studies, and the real practices used at large financial companies, highlighting the weaknesses and pitfalls where needed.
Presented By: Alberto Cherubini
Singapore: 6th - 8th May 2015
This advanced three-day course covers the pricing, hedging and application of FX exotics for use in trading, risk management, financial engineering and structured products.
FX exotics are becoming increasingly commonplace in today’s capital markets. The objective of this workshop is to develop a solid understanding of the current exotic currency derivatives used in international treasury management. This will give participants the mathematical and practical background necessary to deal with all the products on the market.
Presented By: Prof Dr Uwe Wystup
Hong Kong: 12th - 13th May 2015
Singapore: 18th - 19th May 2015
This course explains and describes the valuation adjustments in derivatives pricing in relation to counterparty risk, collateral, funding and capital components. The ideas are built up sequentially and workshops are used to develop the key ideas including simulation of exposure, the impact of risk mitigants and calculation of CVA, DVA, FVA, CollVA, KCVA and MVA.
Presented By: Dr Jon Gregory
Hong Kong: 14th - 15th May 2015
Singapore: 20th - 21st May 2015
Central Counterparties (CCPs) have existed for many years to guarantee performance in exchange traded derivative markets. However, they also offer a similar role in reducing counterparty risk in bilateral over-the-counter (OTC) derivative markets. Regulation stemming from the global financial crisis of 2007 onwards has mandated that many standard OTC derivative transactions must be cleared through a qualifying CCP. This move towards central clearing is therefore going to create a dramatic shift in the topology of financial markets together with a significant reallocation of counterparty and systemic risks and is an important consideration for all financial institutions whether they may be CCP members or alternatively clear trades indirectly.
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