GARP Webcast

Correlation Risk and Why

it is Critical in Finance
Presented by:

Gunter Meissner, Ph.D.

University of Hawaii and CEO, Cassandra Capital Management
Email: gunter@dersoft.com

Tuesday, Oct 21, 2014

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Gunter Meissner, Cassandra Capital Management

After a lectureship in mathematics and statistics at the Economic Academy Kiel,
Gunter Meissner PhD joined Deutsche Bank in 1990, trading interest rate futures,
swaps, and options in Frankfurt and New York. He became Head of Product
Development in 1994, responsible for originating algorithms for new derivatives
products, which at the time were Index Amortizing Swaps, Lookback Options, and
Quanto Options and Bermuda Swaptions. In 1995/1996 Gunter was Head of
Options at Deutsche Bank Tokyo. From 1997 to 2007 he was Professor of Finance
at Hawaii Pacific University and from 2008 to 2013 Director of the financial
engineering program at the University of Hawaii. Currently, Gunter is President of
Derivatives Software Founder and CEO of Cassandra Capital Management, and
Adjunct Professor of Mathematical Finance at NYU-Courant.
Gunter Meissner has published numerous papers on derivatives and is a frequent
speaker at conferences and seminars. He is author of 5 books, including his 2014
book on Correlation Risk Modeling and Management An Applied Guide
including the Basel III Correlation Framework (John Wiley).

Motivation

correlation, while being one of the most ubiquitous

concepts in modern finance and insurance, is also one of the
most misunderstood concepts. (Embrechts et al. 1999)

I think correlation modeling is basically at the stage volatility

modeling was about 15 years ago (Vladimir Piterbarg)

Correlations always increase in stressed markets (John Hull)

Contents Overview

Basics: What are Financial Correlations?

1.1 Investments and Correlation
Model: The Impact of Correlation in the CAPM model
1.2 Trading and Correlation
Model: Dispersion trading is a play on Correlation!
1.3 Risk Management and Correlation
Model: Deriving the Impact of Correlation on VaR (Value at Risk)

1.4 The Global Financial Crisis and Correlation

1.5 Correlation and Regulation
4

1.5 Regulation and Correlation

What are Financial Correlations? Three Interpretations:

1) In Trading Practice: The term correlation is typically used quite loosely for the co-movement of
assets in time.
2) In Financial Theory: The term correlation is often defined narrowly, only referring to the linear
Pearson correlation model, as in Cherubini et al (2004), Nelsen (2006) or Gregory (2010).
The Correlation Haters Club :
Nassim Taleb refers to this narrow definition:
Everything that has to do with correlation, is charlatanism

3) Broader Definition in Financial Theory: The term correlation is also often applied to
generally describe dependencies, as in the terms credit correlation, default correlation or
copula correlation, which are quantified by non-Pearson models as in Heston (1993), Lucas
(1995), or Li (2000).

The heavily criticized Pearson Correlation Model

^
Y (X)

Y (Price of AAPL)

2
1

dY
1
dX

X (Profit Margin)

^
To find Y (X) , we minimize the sum of the squared error terms:
6

min

i 1

i2

The Heavily Criticized Pearson Correlation Model

-1

XY

COVXY
1
X Y

Main Limitations of the Pearson Correlation Model

1) The Pearson correlation model measures the linear association between variables.
As a result, non-linear relationships as Y=X2, cannot be evaluated!
2) For example, a dependence (as in Y=X2), can result in zero correlation!
(see spreadsheet www.dersoft.com/Dependence and Correlation.xlsm)
3) The Pearson correlation coefficient is not robust i.e. it is time frame sensitive
X

30%

25%

25%

20%

20%

15%

15%

10%

10%

5%

5%

0%

0%
1

9 10 11 12 13 14 15 16 17

9 10 11 12 13 14 15 16 17

Figure 2

Figure 1

30%

The Correlation in Figure 1 from time 1

to time 17 is -0.8291

The Correlation in Figure 2 from time 1

to time 17 is 0.9203

The Correlation in Figure 1 from time 1

to time 2, from time 2 to time 3 is 1

The Correlation in Figure 2 from time 1

to time 2, from time 2 to time 3 is -1

Source Wilmott 2013

Main Limitations of the Pearson Correlation Model

n

4) Outliers are over-weighted

1
Variance
n 1

i 1

_
(x i x )2

and can distort

the results

5) Nonsense Correlation possible: E.g. we will find a positive correlation

consumption of Organic Food and Autism
6) Linear correlation measures are only natural dependence measures if the joint
distribution of the variables is elliptical.
7) The variances of the sets X and Y have to be finite. However, for distributions with
strong kurtosis, for example the student-t distribution with v2, the variance is infinite.
8) In contrast to the Copula approach, which is invariant to strictly increasing
transformations, the Pearson correlation approach is typically not invariant to
transformations.

Conclusion: Can We Apply the Pearson Correlation Model in Finance?

For the reasons mentioned, the application of Pearson Correlation

approach in Finance is questionable.

Only if we have a large data set, which is outlier-free, approximately

linear (or linearized), and causally related, can the Pearson model serve
as an approximation for the association between financial variables.

More advanced correlation concepts as Correlating Brownian motions

(Heston 1993), Multivariate Copulas (Li 2000, Albanese 2010),
Stochastic Correlations (Buraschi et al 2010, Lu Meissner 2013) are the
better choice for most financial data.

10

1.1 Investments and Correlation

We can write:

P
f ( Diversification ( n, n ))
P
( ) ( )

The negative relationship of

P
P

or

P
f ( n , n ...)
P
( ) ( )

with respect to n in equation (3) comes from

XY w2X2X w2Y2Y 2 wX w Y X Y XY
for

n {X , Y }

From equation (4), we see that

11

(3)

XY
0
XY

(4)

1.1 Investments and Correlation

Example 1.1

Year
2008
2009
2010
2011
2012
2013

Asset X
100
120
108
190
160
280

Asset Y
200
230
460
410
480
380
Average

Return of asset X

Return of asset Y

20.00%
-10.00%
75.93%
-15.79%
75.00%
29.03%

15.00%
100.00%
-10.87%
17.07%
-20.83%
20.07%

it follows:

Figure 1.3: The negative relationship of the portfolio return - portfolio risk ratio P/P with respect to the
correlation of the assets in the portfolio.
www.dersoft.com/Investment and Correlation.xlsx
12

1.2 Trading and Correlation

Okane dake des (Its only money) Japanese saying

Every major investment bank and hedge fund has Correlation Desks.
Many Correlation dependent Products and Strategies are traded:

- Correlation Swaps

2
I

- Dispersion Trading

w i2 i2

i 1
N 1 N

ij
2

w i w j i j

i 1 j i

- Correlation dependent Options as Exchange Options

13

Payoff = max(0, S2-S1)

1.2 Trading and Correlation

The price of Multi-asset options, also called Rainbow options, or Mountain range
options depends critically on Correlation between the Assets!
- Option on the better of two. Payoff = max (S1, S2)
- Option on the worse of two. Payoff = min (S1, S2)
- Call on the maximum of two. Payoff = max [0, max(S1,S2) K]
- Exchange option (as imbedded in a convertible bond). Payoff = max (0, S2 S1)
- Spread call option. Payoff = max [0, (S2 S1) - K]
- Option on the better of two or cash. Payoff = max (S1, S2, cash)
- Dual strike call option. Payoff = max (0, S1-K1, S2-K2)

- Portfolio of basket option. Payoff n iSi K, 0 where ni is the weight of assets i

i 1

For all options above, except one, we have

14

V
0

V : Option value

Dispersion Trading A Play on Correlation

Long Dispersion trading is selling options on an index (e.g. S&P) and

buying options on individual stocks in the index, and vice versa.

Dispersion trading is a play on correlation (between the assets in the index)!

So Dispersion trading is effectively Correlation trading!

15

Dispersion Trading Example

Scenario 1: We have an index I of 20 stocks, which have performed as in Figure 1:

Index Performance
0.8

S
t 0.6
a
0.4
n
d 0.2
a
0
r
d -0.2

Figure 1:
Low Correlation ij

m -0.4
o -0.6
v
e -0.8
1

9 10 11 12 13 14 15 16 17 18 19 20

Stock number

In Figure 1, the (Standard moves), i.e. I = 0

A long dispersion trade of long options (straddles) on the stocks 1 5 and short options
(straddles) on the index I would be a successful trade!

16

Long Dispersion Trading Scenarios

Scenario 2: We have an index I of 20 stocks, which have performed as in Figure 2:

Index Performance
S
t
a
n
d
a
r
d

0.7
0.6
0.5
0.4

Figure 2
High Correlation ij

0.3
0.2

m 0.1
o
0
v
e -0.1
1

9 10 11 12 13 14 15 16 17 18 19 20
Stock number

Our long dispersion trade of long options (straddles) on the stocks 1 5 and short options
(straddles) on the index I is now a disaster.
A short dispersion trade of short options (straddles) on the stocks 1 5 and long options
(straddles) on the index I would have been the correct trade.
17

Dispersion Trading Why is it a Play on Correlation?

From Stats 101, we remember:

VarXY VarX VarY 2COVXY

(4*)

Generalizing for N assets, for our index I, with Var 2 we have

N 1 N

2I

wi2i2 2

i 1

wi w ji j ij

(1)

i 1 ji

Solving for the correlation ij between the N asset in the index I, we get
N

2I

i 1
N 1 N

ij
2

i 1 ji

Equation (2) shows the general concept:

w i2 i2

w i w j i j

(2)

ij f( I , i 1,...,N )
See File www.dersoft.com/Dispersion.xlsx

The CBOE publishes the ICJ, ICK Correlation indexes, which consist of 50 stocks, tracking the S&P 500. These indexes
are designed to reflect the average correlation of the 50 stocks, i.e. the bid and ask vols are averaged. So ij average.
18

Dispersion Trading Why is it a Play on Correlation?

From equation (1)

N 1 N

2I

wi2i2 2

i 1

wi w ji j ij

we derive

i 1 ji

2I

ij

From equation (2)

N

2I

w i2 i2

i 1
N 1 N

ij
2

w i w j i j

i 1 ji

The equations

ij
0
we derive
2
i
2I

ij

and

or

i2

ij

i2

ij

tell us that

If we expect an increase in ij buy options (straddles) on I and sell options (straddles) on individual
stocks i (short dispersion) [typically in a Recession]
Vice versa, if we expect an decrease in ij sell options (straddles) on I and buy options (straddles) on
individual stocks i (long dispersion) [typically in an Expansion]
19

1.3 Risk Management and Correlation How is Risk Quantified?

1) Volatility ( Standard deviation of Returns)

For a 2-asset portfolio:

For a n>2 asset portfolio P:

XY w2X2X w2Y2Y 2 wX w Y X Y XY

P h C v
r
SP P
P

2) Sharpe ratio (Risk adjusted Return):

Extension: Sortino ratio:

20

(1)

S*P

P r
P (negative Returns)

3) Value at Risk (parametric):

VaR P X

4) Expected Shortfall (parametric):

ES E[L | L VaR]

5) Extreme Value Theory:

n (x u)

F(L x) u 1
n

ES VaR
1/

1.3 Risk Management and Correlation

The impact or Correlation in the VaR model

VARP = P x

P =

h C v

h is the horizontal vector of invested amounts (price x quantity)

v is the vertical vector of invested amounts (price x quantity)
C is the covariance matrix

21

1.3 Risk Management and Correlation

The Covariance matrix for a 2-asset portfolio is

cov11 cov12

cov
cov
21
22

Example 1.1: What is the 10-day VaR for a 2-asset portfolio with a correlation coefficient of
0.7, daily standard deviation of returns of asset 1 of 2%, asset 2 of 1%, and $10 mio invested
in asset 1 and $5mio invested in asset 2, on a 99% confidence level?
cov11 = 1 1
cov12 =
cov21 =
cov22 =

22

12

1 1
1 2

1 x 0.02 x 0.02 = 0.0004

0.7 x 0.02 x 0.01 = 0.00014

2 1 2 1 0.7 x 0.01 x 0.02 =

2 2 2 2 1 x 0.01 x 0.01 =

0.00014
0.0001

1.3 Risk Management and Correlation

P h C v

h C

(10 5) 0.0004 0.00014

0.00014

0.0001

(h C) v

= (10x0.0004+5x0.00014 10x0.00014+5x0.0001) = (0.0047 0.0019)

0.0047

10
0.0019 10x0.0047 5x0.0019 5.65%
5

P hC v 5.65% 23.77%
Applying

VARP = P x

for a 99% confidence level, = normsinv(0.99) = 2.3264 and for a x=10 day time horizon,

VARP = 0.2377 x 2.3264 x 10 =

23

1.7486

1.3 Risk Management and Correlation

VAR with respect to correlation

1.9
1.8
1.7
1.6
V 1.5
A
1.4
R
1.3
1.2
1.1
1
-1

-0.8

-0.6

-0.4

-0.2
0
0.2
Corrleation

0.4

0.6

0.8

Figure 1.6: VaR of the two-asset portfolio of example 1.1 with respect to correlation
between asset 1 and asset 2.

see Model at www.dersoft.com/2-asset VaR.xlsx

24

1.4 The Global Financial Crisis and Correlation

Copulas (Sklar 1959, Vasicek 1987, Li 2000)
Copula Milestones
Founder: Abe Sklar 1959
C[QA (t), QB(t),...,Qn (t)] Mn [N -1(Q A (t)), N-1(Q B(t)),..., N-1(Q n (t)); M ]
mapping, which results in an abscise value of a standard normal dist

Vasicek 1987 derives a one-factor Gaussian CVaR:

Later more

N 1(PD(T)) N 1X

V(X, T) N

applied in Basel IIs IRB approach

David Li 2000 On Default Correlation: A Copula Function Approach

An Introduction to Copulas Roger Nelson 1998, second ed. 2006

Copula Methods in Finance Cherubini et al 2004

25

1.4 The Global Financial Crisis and Correlation

Can we blame the Copula Correlation Model for the Global Financial Crisis?
Recipe for Disaster: The Formula that killed Wall Street Wired Magazine (2009)
Wall Street Wizards Forgot a Few Variables New York Times (2009)
Confessions of a Risk Manager The Economist (2008)

The reason for the Global Financial Crisis can be summed up in one word:

Greed
Resulting in irresponsible Overinvesting and Risk-taking:
AIG hat sold 500 billion in CDSs. Their risk management strategy was

Icelands banks had borrowed and invested 10 times the national GDP
In 2007, the US debt ratio was 470% of national income!!!

26

Can We Blame the Copula Correlation Model for the Global Financial Crisis?

Naturally, we need general mindfulness about financial models and not trust them uncritically:
David Li: The most dangerous thing is when people believe everything that comes out of it
Models are not perfect. That doesnt man they are not useful Robert Merton
(See also Chapter 3.1 in Correlation book)

A major problem in the global financial crisiss was inadequate Calibration!

Models as VaR, CVaR, Copulas to value CDOs, were fed benign vol and correlation data!

If a model is fed wrong input data, it cant be expected that is produces correct results!
Garbage in, garbage out!!
Models are now stress tested, required and supervised by Basel III, Fed, ECB..

27

1.5 Correlation and Regulation

An Overview

Figure 12.4: CVA (Credit Value Adjustment) and WWR (Wrong Way Risk) in the Basel III framework.
Source: Moodys Analytics 2011.

28

1.5 Correlation and Regulation

Basel II (and III) applies the OFGC (One-factor Gaussian Copula)

Correlation Model to derive CVaR (Credit Value at Risk). Too simplistic???
More on CVaR later
Basel III applies Correlations between Credit exposure = f(Market) and
Credit risk, i.e. wrong-way risk (WWR) to derive CVA (Credit Value Adjustment)

Credit Risk

Market Risk

More on CVA later

Basel III recognizes credit exposure, which is hedged (e.g. with CDS)
and allows two Correlation Concepts for Double-Default
More on Basel IIIs two Double Default Approaches later
29

CVA (Credit Value Adjustment) Approach WWR (Wrong Way Risk)

in the Basel Accord

What is CVA (Credit Value Adjustment)?

Definition: CVA is a specific capital charge to address counterparty risk

However, CVA is typically defined narrower referring to counterparty risk in

Derivatives transactions.

30

CVA (Credit Value Adjustment) Approach with WWR (Wrong Way Risk)
in the Basel Accord

Why CVA?
Basel committee: 2/3 of the credit risk losses during the global financial crisis
were caused by CVA volatility rather than actual defaults
AIG had sold close to $500 billion in CDSs!!! Needed bailout of $180 billion!
When Lehman defaulted in September 2008, it had 1.5 million derivative
transactions with 8,000 different counterparties...

Trading and Hedging CVA

Financial Institution do not want to pay CVA. Therefore the vast majority of
financial institution has CVA desks, where CVA is traded and hedged.

31

CVA (Credit Value Adjustment) Approach with WWR (Wrong Way Risk)
in the Basel Accord Basics

CVAa,c = f (D+a,c, PDc)

(12.11)

(12.11)

Market risk Credit risk

CVAa,c : Credit Value Adjustment of entity a with respect to the counterparty c

D+a,c: Netted, positive derivatives portfolio value of entity a with counterparty c
PDc : Default probability of counterparty c
Market risk or Market price changes determine the Credit Exposure.
E.g. Bank a has a long put on a bond of Greek Bond BG bought from
counterparty c. If BG Credit exposure of a with respect to c, since D+a,c
Intuitive way to look at WWR: When credit exposure and credit risk both
tend to increase together (are positively correlated).

32

CVA (Credit Value Adjustment) Approach with WWR (Wrong Way Risk)
in the Basel Accord

What is Wrong Way Risk (WWR)?

Two types of WWR exist

1) General wrong-way risk exists when the probability of default of a counterparty is
positively correlated with general market risk factors (BCBS 2003)

An example of general WWR is a bond:

Higher credit exposure

(12.7)

PDc

Higher credit risk

Intuitive way to look at WWR: When credit exposure and credit risk both tend to
increase together (are positively correlated).

33

CVA (Credit Value Adjustment) Approach with WWR (Wrong Way Risk)
in the Basel Accord

The second type of WWR is specific WWR

A bank is exposed to specific wrong-way risk (WWR) if future exposure
to a specific counterparty is positively correlated with the counterpartys
probability of default (BCBS 2011)
We can formulize specific WWR as

PDc
0

D a,c

Credit risk
(12.13))

Credit exposure

Where D+a,c is the netted positive Derivatives value of a with respect to the
counterparty c and PDc is the prob of default of a counterparty c.
34

An Example of Specific WWR:

Fixed CDS spread s

Investor and
CDS buyer i

$M million

Payout of $M(1-R)
million in case of
default of obligor o

Guarantor g
i.e. CDS seller

(12.8)

coupon k

Reference asset
of obligor o

Specific WWR exists if there is a positive correlation between the obligor o and the guarantor g:

PV(CDS) for i

Higher credit exposure

(PDo PDg)
P of payoff

35

Higher credit risk

(12.9)

What if o and g are identical??? See model CDS with default correlation.

Critical Appraisal of Basels CVA

Pros
Is necessary in light of the 2007-2009 crisis
The WWR correlation approach is also necessary. Basels factor =1.2 to 1.4,
which is multiplied to CVA if WWR exists, is a simple way to deal with WWR.

Cons
Basels =1.2 to 1.4, while conservative (banks report 1.07 to 1.1), is simplistic.
More rigorous WWR correlation models are being developed (Hull, Meissner)
CVA needs inputs of PD until end of the exposure, which can be up to 30
years. PD data unreliable for this time frame.

36

Concluding Summary

Correlations are ubiquitous in Finance, but not very well understood.

The most popular approach, the Pearson Correlation model has

significant limitations in Finance!
Correlations are especially critical in Risk Management, especially
Credit Risk Management, as seen in the global financial crisis, since
Correlations change (typically increase) in stressed markets.

Correlation modeling is in the beginning stages. Several promising

approaches as stochastic Correlation models are emerging.

37

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