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

A correlation swap on two stocks has a notional of USD 1,000,000, a fixed (strike) correlation of 0.40, and the buyer receives realized correlation minus strike times notional. At maturity, the realized correlation is 0.25. What is the payoff to the buyer (the receiver of realized correlation)?

The buyer's payoff is minus USD 150,000. A correlation swap pays notional times realized correlation minus strike, so 1,000,000 times (0.25 minus 0.40) gives a loss to the buyer, who receives realized correlation, because realized fell below the fixed strike.

  1. A-USD 150,000Correct
  2. B+USD 150,000
  3. C-USD 65,000
  4. D+USD 650,000

Explanation

Payoff = notional x (realized - strike) = 1,000,000 x (0.25 - 0.40) = -150,000. A positive sign would reverse the direction and would be the seller's payoff. The other values come from incorrect arithmetic.

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