Cutting Edge introduction: Hedging dependence

Since cross-asset class correlations aligned in 2008 there has been pent-up demand for instruments that provide exposure to another measure of it – covariance. But structuring a covariance swap that can be hedged simply has been a challenge. Laurie Carver introduces this month’s technical articles

Much has been said about how pre-crisis quantitative methods neglected the way price movements for different assets can depend on each other – most infamously so, the Gaussian copula, the simplifying assumptions of which failed so drastically that nonsensical correlation values of more than 100% were required to calibrate to market prices.

One of the lessons was that correlation is not everything when it comes to how price movements interrelate – joint distributions in general need many more