A research on hedging strategy of correlation risk when extreme events happen

XIAO Yang, CHEN Jing-ping

Systems Engineering - Theory & Practice ›› 2015, Vol. 35 ›› Issue (3) : 587-597.

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Systems Engineering - Theory & Practice ›› 2015, Vol. 35 ›› Issue (3) : 587-597. DOI: 10.12011/1000-6788(2015)3-587

A research on hedging strategy of correlation risk when extreme events happen

  • XIAO Yang, CHEN Jing-ping
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Abstract

When extreme events happen in the world, the correlation risk among assets rises outstandingly. So how to prevent and hedge the correlation risk in advance becomes an important subject for financial risk management and emergency management. Indeed, the volatility of index is influenced by the market liquidity, stock volatility and the correlation coefficient among stocks, while the stock volatility is not influenced by the correlation coefficient. Therefore, when the extreme events happen, the volatility of index will increase significantly because of the increasing correlation coefficient among assets. As a result, the price of index option will increase substantially. While the price of stock option is only influenced by the stock volatility and is irrelevant to the correlation coefficient, then the difference between stock index option price and the price of stock options contains the "correlation risk premium". Therefore, in theory, the index option can be used to hedge the correlation risk because the index option price contains the "correlation risk premium". Finally, in order to establish a trading strategy to hedge the correlation risk among stocks, we compare the index volatility risk and the stock volatility risk, strip out the correlation risk among stocks, and then hedge the correlation risk. In this paper, we use the Hang Seng Index option and its component stocks for empirical research. The date ranges from March 1, 2007 to August 31, 2011. The empirical result shows that when the extreme events happen, the correlation risk among the Hang Seng Index stocks increases significantly. The correlation trading strategy built in this paper can be used to hedge the correlation risk among stocks in the portfolio and it makes a contribution to control and prevent the correlation risk among stocks in advance, and gives investors a certain amount of revenue.

Key words

extreme events / risk prevention / correlation risk / correlation trading strategy

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XIAO Yang , CHEN Jing-ping. A research on hedging strategy of correlation risk when extreme events happen. Systems Engineering - Theory & Practice, 2015, 35(3): 587-597 https://doi.org/10.12011/1000-6788(2015)3-587

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