Covariance Leg Terms

From Open Risk Manual


Covariance Leg Terms. A statistical leg based on covariance. REVIEW: This kmight specify the same kind of thing as Correlation Leg using different mathematics / different legal terms (in which case we need to model it as a different thing even though to the investor it has the same rationale and behavior. The relative movement of one thing to the other over a period of time. So this adds a time base to the Correlation calculation. difference with Correelation: The time base in correlation swap is implicit anyway (it's the duration of the contract. so Covariance is what allows you to explan x% of the vaqriabiltiy of the price of this asset with relation to that asset.

Issues and Challenges

Original review note: Co-variance Leg Another statistical swap leg type where the stike determines the payout. Structured the same as the Correlation Leg. more notes 17 March: Covariane is actually the way you measure correlation. So people talk about this as a statistical leg but actually Talks about movement of price THe highter the covariance between two prices the more correlated they are. more general note: unlike fx market where e.g. I cna build a price out od AUS/USD and build a price out of that. In option markets I don't have that opportunity - one owiuld end up overpricing the option. The variability in the price of AUS/USD v AUS/GBP impacts on these calculations. By using three legs I cna put together a cros inthe options. Buy Aus/USD Option, .buy USD/GBP Option and sell the correlation Swap. This sells the correlationbeteen AUS/USD and AUS/GBP leaving me with a realistic price for AUS/GBP thereby enabling me to cross markets. So the swap enables me not to end up overpricing the option. THis basic principle is why correslation swaps are used. So correslation is a relatively new concept.


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