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

Which feature best distinguishes a correlation swap from a variance swap used to trade implied correlation?

A correlation swap settles on realized correlation, typically the average pairwise correlation across a basket, against a fixed strike, whereas a variance swap settles on the realized variance of a single underlying against a variance strike. Both have strikes and trade on many asset classes.

  1. AA correlation swap pays on the average pairwise realized correlation, while a variance swap pays on realized variance of a single underlyingCorrect
  2. BA correlation swap has no strike while a variance swap does
  3. CA correlation swap pays on the level of interest rates
  4. DA variance swap can only be traded on bonds

Explanation

A correlation swap settles on realized correlation (often the average of pairwise correlations in a basket) against a fixed strike. A variance swap settles on realized variance of one underlying. Both have strikes, and neither is restricted to rates or bonds.

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