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

A dealer enters a correlation swap with a notional of USD 1,000,000 per unit of correlation point, where the buyer pays a fixed strike correlation of 40% and receives the realized average pairwise correlation of the basket. Payoff is notional x (realized - strike), with correlation in percentage points. The realized average correlation at maturity is 55%. What is the payoff to the buyer?

The buyer receives USD 15,000,000. Realized correlation of 55% exceeds the 40% strike by 15 points, and with USD 1,000,000 per point the payoff is 15 times that. The buyer is long realized correlation, so the positive difference is a gain.

  1. AUSD 15,000,000Correct
  2. BUSD 150,000
  3. CUSD 15,000
  4. D-USD 15,000,000

Explanation

Realized minus strike = 55 - 40 = 15 percentage points. Payoff = USD 1,000,000 x 15 = USD 15,000,000. The sign is positive because the buyer receives realized and pays fixed, so the negative option reverses the sign. The smaller figures mis-scale the notional.

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