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Assume I have two assets A and B that are positively correlated most of the time. I'm trading a strategy based on this correlation. Is there a way to protect myself in the event that the correlation tears?

After some googling I found there are OTC correlation swaps for the purpose. However, there seems to be no similar exchange-traded products.

I do not have access to the OTC market and therefore I'm wondering if I can replicate a similar portfolio using vanilla options of A and B, as well as the underlyings, to achieve:

  1. When correlation is positive & high, I'm paying "premium" for the insurance.
  2. When correlation is low or even negative, my insurance pays off.
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2 Answers 2

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That's impossible. Since neither the vanilla options nor the underlyings have any exposure to the correlation, no portfolio of these instruments can either.

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  • $\begingroup$ Thanks for the answer. If there are fundamental reasons to support the correlation, eg. dollar vs gold, would you still say they don't have any exposure to the correlation? $\endgroup$
    – zuhao
    Commented Jul 7, 2016 at 1:34
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Exchanges list some options on spreads, such as crack spreads, spark spreads, etc, so that could provide with you a two factor correlation exposure. But if you are long only two underlyings, it is unlikely you will find an option on the sum of the two. If you happen to have an approximately index weighted portfolio of stocks, then of course index options would be useful, but it doesn't sound like you are looking for this.

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