Correlation Products and Risk Management Issues
14 Pages Posted: 11 Nov 2007
Unlike standard derivatives instruments, correlation products contain nonseparable risk, meaning that the price sensitivity of one risk factor is a function of the level of another risk factor. This article outlines the pricing and hedging of one type of correlation product, the differential swap, to show how nonseparable risk may escape traditional methods of assessing the risk of institutions' portfolios. The article considers the implications of correlation products for supervisory and institutional practices and concludes with a brief discussion of some ways nonseparable risk may be managed.
Keywords: differential swap, nonseparable risk
JEL Classification: G11, G12, G15
Suggested Citation: Suggested Citation