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FRM Part II · FRM Exam Part II · Correlation Basics: Definitions, Applications, and Terminology

A correlation swap has a notional of USD 1,000,000 per unit of correlation, with a fixed (strike) correlation of 0.40. At maturity the realized average pairwise correlation of the reference assets is 0.55. The payoff is notional times (realized minus strike). What does the fixed-correlation payer (long correlation, pays strike, receives realized) receive?

The long-correlation party receives USD 150,000, because the payoff equals the notional of USD 1,000,000 multiplied by the difference between realized correlation of 0.55 and the strike of 0.40, which is 0.15.

  1. AUSD 150,000Correct
  2. BUSD 400,000
  3. CUSD 550,000
  4. DUSD 15,000

Explanation

Payoff to the receiver of realized correlation = 1,000,000 x (0.55 - 0.40) = USD 150,000. Using the strike alone or realized alone ignores the netting; USD 15,000 misplaces the decimal.

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