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

A portfolio manager holds a long position in a two-asset basket call option (payoff on the basket of the two assets) and is concerned about correlation exposure. Which statement about the sensitivity of the option value to correlation is correct?

The long basket call gains value when correlation rises, because higher correlation increases the volatility of the basket through the covariance term, and option value increases with volatility, even if individual asset volatilities stay the same.

  1. AValue falls as correlation rises, because basket volatility declines
  2. BValue rises as correlation rises, because basket volatility increasesCorrect
  3. CValue is unaffected by correlation if individual volatilities are fixed
  4. DValue rises as correlation falls, because diversification improves

Explanation

Basket variance includes the covariance term, so higher correlation raises basket volatility. Since option value increases with volatility, a long basket call has positive correlation sensitivity. Choice A and D reverse the relation; C ignores the covariance term.

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