An Intuitively Valid Algorithm for Adjusting the Correlation Matrix in Risk Management and Option Pricing
11 Pages Posted: 6 Jan 2012 Last revised: 15 Aug 2012
Date Written: 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.
Keywords: Adjusting correlation, stress testing, correlation matrix
JEL Classification: G13, G20, C63
Suggested Citation: Suggested Citation