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

A dispersion trader holds a long position in single-stock options and a short position in index options. Under which view on correlation is this trade expected to be profitable?

A dispersion trade, long single-stock options and short index options, is effectively short correlation. It profits when realized correlation turns out lower than the implied correlation embedded in index option prices, because stocks move more independently than the market priced in.

  1. ARealized correlation will be lower than the correlation implied by option pricesCorrect
  2. BRealized correlation will be higher than the implied correlation
  3. CCorrelation will equal one
  4. DVolatility of all stocks will fall to zero

Explanation

Index variance depends on single-stock variances and correlations. Being long single-stock volatility and short index volatility is effectively short correlation. It profits if realized correlation ends below the implied level priced in the index options.

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