An Intuitively Valid Algorithm for Adjusting the Correlation Matrix in Risk Management and Option Pricing
Phatra Securities; Mahidol University - Department of Mathematics
Mahidol University - Department of Mathematics
January 15, 2012
Adjusting the correlation matrix plays an important role in risk management as well as option pricing. We usually adjust the correlation matrix by directly changing the correlation coefficient in the correlation matrix. However, there is a chance that the adjusted correlation matrix is not valid. In this paper, we present a new algorithm for adjusting the correlation matrix that maintains its validity. Furthermore, the correlative relationship among the assets that we do not want to adjust will not be affected by the adjustment. Therefore, the solution obtained from our new algorithm is considered to be intuitively valid.
Number of Pages in PDF File: 11
Keywords: Adjusting correlation, stress testing, correlation matrix
JEL Classification: G13, G20, C63working papers series
Date posted: January 6, 2012 ; Last revised: August 15, 2012
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