Implied Basket Correlation Dynamics

TL;DR

This paper investigates implied basket correlation dynamics, proposing a simplified equicorrelation model and a dynamic factor approach to improve the profitability of dispersion strategies based on implied correlation forecasts.

Contribution

It introduces a novel equicorrelation assumption and a dynamic semiparametric factor model to analyze implied correlation surface dynamics for better strategy performance.

Findings

Improved dispersion strategy profitability using implied correlation forecasts

Effective dimensionality reduction via equicorrelation assumption

Dynamic factor model captures implied correlation surface changes

Abstract

Equity basket correlation can be estimated both using the physical measure from stock prices, and also using the risk neutral measure from option prices. The difference between the two estimates motivates a so-called "dispersion strategy''. We study the performance of this strategy on the German market and propose several profitability improvement schemes based on implied correlation (IC) forecasts. Modelling IC conceals several challenges. Firstly the number of correlation coefficients would grow with the size of the basket. Secondly, IC is not constant over maturities and strikes. Finally, IC changes over time. We reduce the dimensionality of the problem by assuming equicorrelation. The IC surface (ICS) is then approximated from the implied volatilities of stocks and the implied volatility of the basket. To analyze the dynamics of the ICS we employ a dynamic semiparametric factor model.