An easy-to-hedge covariance swap

Covariance swaps that track the covariance of assets can be difficult to hedge because there is no known static replication formula, unlike the case for variance swaps. However, in the case of swaps measuring the covariance between the absolute returns of an equity and a foreign exchange rate, it is possible to hedge the contract using a static hedge in two equity quanto forwards and a dynamic hedge in the stock and the forex rate. By Per Hörfelt, Sudhansu Kajbaje, Davit Sahakyan and Jinguo Zhao

Since the seminal papers by Neuberger (1990) and Dupire (1993), contracts on volatility and correlation have been of increasing interest. Volatility and correlation products are actively traded on exchanges and over-the-counter. In particular, contracts that pay the realised variance of the log returns of the underlying asset have become a popular product. Part of the reason for their popularity is that they can be perfectly hedged with a static portfolio of European-style call and put options