Much Ado About Correlation

Apr 1, 2007

Correlation is at once an old and new problem in risk: old because it is a necessary parameter of all risk models, and new because it now drives pricing of a growing class of financial products. While most of us are wise enough to worry about correlation risk, this concept tends to mean different things to all of us. In this piece, we attempt to sort out the various problems that fall under the label of correlation risk, and at the same time try to distinguish between correlations that move (some of them) and correlations that are just hard to estimate (all of them). We argue that some of the problems essentially amount to assessing parameter uncertainty; others do necessitate a look at new risk factors, but on further examination, the modeling challenges these introduce are not insurmountable.