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

An investor wants to profit if the correlation among stocks in an index rises, without taking a view on index direction. Which position is most consistent with this objective?

Paying the fixed leg and receiving realized correlation is the long correlation position. It profits when realized correlation exceeds the strike, independent of index direction. The opposite swap position loses in that case, and option positions mainly depend on direction or single-name volatility.

  1. AReceive the fixed leg and pay realized correlation in a correlation swap
  2. BPay the fixed leg and receive realized correlation in a correlation swapCorrect
  3. CSell a put option on the index
  4. DBuy a single-stock straddle on one constituent

Explanation

A long correlation position gains when realized correlation exceeds the strike. The payer of fixed and receiver of realized correlation gains when correlation rises. Receiving fixed and paying realized is short correlation. The option positions are driven by direction or single-name volatility, not correlation.

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