FRM Part II · FRM Exam Part II · Correlation Basics: Definitions, Applications, and Terminology
A dealer sells a correlation swap paying realized average correlation on a basket of three stocks. The pairwise realized correlations are 0.30 (A,B), 0.50 (A,C) and 0.70 (B,C). Using the simple average of pairwise correlations, what is the realized correlation used for settlement?
Settlement correlation is 0.50, the simple average of the three pairwise correlations: 0.30 plus 0.50 plus 0.70 equals 1.50, divided by three pairs.
- A0.45
- B0.50Correct
- C0.55
- D0.60
Explanation
Average = (0.30 + 0.50 + 0.70)/3 = 1.50/3 = 0.50. 0.45 and 0.55 result from arithmetic slips; 0.60 is wrongly weighting the highest pairs.
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