Correlation Swaps for Trading Changes in Asset Correlation

Summary

The document asks how to build a commodity futures strategy whose expected profit varies with the difference between daily-return correlation and two-day-return correlation, scaled by the assets’ volatilities. The proposed exposure is connected to a correlation swap, a contract designed to pay according to realized correlation. The response points to a thesis on static replication of European options and dynamic replication of correlation swaps as a potential reference for implementation.

The exchange gives no trading recipe, replication steps, pricing details, or empirical evidence. It emphasizes that constructing the exposure is nontrivial, so the cited reference is a starting point rather than a turnkey strategy. The discussion also leaves practical questions unanswered, including how to translate the correlation exposure into positions in commodity futures and how to manage basis, liquidity, and estimation risks.

Key ideas

• The stated payoff relationship depends on the difference between daily and two-day return correlations, scaled by both assets’ volatilities.
• A correlation swap is identified as a derivative that may provide the desired correlation exposure.
• Static option replication and dynamic replication are cited as topics for further study.
• The response does not provide an implementation method or evidence that the proposed exposure is profitable.

Tags

# How to design a strategy whose PnL is proportion to correlation?


# How to design a strategy whose PnL is proportion to correlation?












I'm reading about this correlation breakout strategy, whose pnl is proportional to

$$E[PnL] \sim (\rho_{1D} - \rho_{2D})\sigma_1 \sigma_2$$

where $\rho_{1D}$ is the correlation of daily returns, and $\rho_{2D}$ is the correlation of 2day returns.

How to actually achieve this with, if the two assets are commodity futures?

## Answer by Yike Lu (score 5)

https://quant.stackexchange.com/a/77911

You are looking for a correlation swap. There is a PhD thesis on static replication.

> Sébastien Bossu. Static replication of European options and dynamic replication of correlation swaps. Business administration, Université Paris-Saclay, 2021.

As you would expect, it is not a trivial task.

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