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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

Kawee Numpacharoen

Phatra Securities; Mahidol University - Department of Mathematics

Kornkanok Bunwong

Mahidol University - Department of Mathematics

Date Written: January 15, 2012

Abstract

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

Numpacharoen, Kawee and Bunwong, Kornkanok, An Intuitively Valid Algorithm for Adjusting the Correlation Matrix in Risk Management and Option Pricing (January 15, 2012). Available at SSRN: https://ssrn.com/abstract=1980761 or http://dx.doi.org/10.2139/ssrn.1980761

Kawee Numpacharoen (Contact Author)

Phatra Securities ( email )

Bangkok, 10310
Thailand

Mahidol University - Department of Mathematics ( email )

Bangkok, 10400
Thailand

Kornkanok Bunwong

Mahidol University - Department of Mathematics ( email )

Bangkok, 10400
Thailand

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