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I read from various sources (eg. Exotic Options and Hybrids, M. Bouzoubaa) that the correlation sensitivity of Rainbow options (say a call price on a basket made of 50% of the best stock, 20% of the worst, 30% of the 3rd one) is uncertain due to 2 opposite effects:

  • Increasing correlation would increase the overall basket volatility, thus tends to push the option price higher

  • Increasing correlation would decrease the Forward price, thus tends to push the option price lower

I do not understand the reason for the 2nd point - how come an increase in correlation decreases the Forward price?

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  • $\begingroup$ See my comment in zrh's answer. $\endgroup$
    – will
    Commented May 4, 2019 at 16:50

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The second point is obviously wrong. Correlations do nothing to the expected basket return, they will only affect the variance of the basket return.

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    $\begingroup$ This is wrong. If the basket has some optional it in it, ie a worst of/best of, which a rainbow basket can be described as, then the correlation does have an impact on the forward. $\endgroup$
    – will
    Commented Mar 16, 2019 at 13:19
  • $\begingroup$ ok, can you point us to a reference ? $\endgroup$
    – ZRH
    Commented Mar 16, 2019 at 13:40
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    $\begingroup$ i don't have one no. It's pretty obvious though, given the example in the question (50% best, 30% 2nd best, 20% worst), we can write it as a $0.9 \cdot \mathrm{equal weighted basket} + 0.2 \cdot \mathrm{best of} - 0.1 \mathrm{worst of}$. So correlation has no effect on the first term, but the min/max are effected by correlation (you can see the distributions here). $\endgroup$
    – will
    Commented Mar 17, 2019 at 14:20

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