Breaking correlation breaks

Large deviations in dependencies – correlation breaks – are a hazard when risk managing multi-asset derivatives such as worst-of options. Adil Reghai presents a calibration scheme for local correlation that ensures a basket’s skew is compatible with the local volatility dynamics of its constituents – and leads to more accurate hedging

Local correlation has been thoroughly studied in physics in order, for instance, to describe interactions between electrons. In financial mathematics, most research on correlation comes from the credit derivatives industry, such as deriving joint-default distributions consistent with the correlation skews observed on collateralised debt obligation tranches quotes thanks to local Gaussian copulas (Burtschell, Gregory & Laurent, 2005). In equity derivatives, Avellaneda et al (2002) approximated