0
$\begingroup$

Are correlation swaps sensitive to stochastic volatility? Can you please justify from a theoretical point of view?

Improve this question
$\endgroup$

1 Answer 1

Reset to default
1
$\begingroup$

I guess you ask if there is a difference if you model them via stochastic vol as opposed to local vol for example? If so, yes. The effect is called decorrelation. Since SV has vols fluctuate as opposed to deterministic, you get more variation in the price of the underlyings. Hence, your effective realized correlation is smaller in SV.

Improve this answer
$\endgroup$
2
  • $\begingroup$ Thanks a lot for your reply, AKdemy. The argument sounds good. But will it be a significant change as compared to the local vol is a valid question. Because stochastic vol may not necessarily increase the randomness of the underlying stock and decorrelate. We may simply need a very high value of vol for the decorrelation effect, not necessarily a stoch vol. $\endgroup$
    – Toby1729
    May 10, 2021 at 8:31
  • $\begingroup$ No matter your level of vol, LV will never decorrelate as vol is deterministic. ellie_cat added a good comment about validity of LV. I also mentioned here that LV is often actually close to market quotes. $\endgroup$
    – AKdemy
    May 10, 2021 at 9:01

Your Answer

By clicking “Post Your Answer”, you agree to our terms of service and acknowledge that you have read and understand our privacy policy and code of conduct.

Not the answer you're looking for? Browse other questions tagged or ask your own question.