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December 2006 issue
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Wong
Matheron
Davig, Gerlach
Rudebusch
Jensen
Kearns, Manners
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Basel II and the Risk Management of Basket Options with Time-Varying Correlations

by Amy S. K. Wong
Tinbergen Institute, Erasmus University Rotterdam

Abstract

The impact of jumps, regime switches, and linearly changing correlation term structures on the risk management of basket options has been examined in this paper. First, the results show that there is an asymmetric correlation effect on the value-at-risk of basket options. Second, the time at which a correlation shock occurs during the life of an option is particularly important for hedged basket options. Finally, the square-rootof- time rule can lead to severe underestimation of value-at-risk for basket options with time-varying correlations – for some cases, even by a factor exceeding the minimum regulatory stress factor.

JEL Codes: G15, G21.

 
Full article (PDF, 31 pages 386 kb)