A Note on Implied Correlation for Bivariate Contracts

Abstract

In this paper we develop a framework in which implied correlation can be rigorously defined for a class of derivative contracts written on two assets. Within this class, we show that implied correlation exists and is unique provided that the observed two-asset contract price is free of arbitrage. We also obtain an analytic result to compute the sensitivity to implied correlation of a contract's price. We then provide a numerical illustration of these results applied to spread options.

Keywords: Bivariate Contracts, Implied Correlation, Risk Management

JEL Classification: G13, C52