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Glossary
A structured product that provides capital protection offers an amount that at least matches a given proportion of the investor’s original capital input at maturity. Can also be referred to as principal-protected.
Correlation is a measure of the degree to which changes in two variables are related.It is normally expressed as a coefficient between plus one, which means variables are perfectly correlated (in that they move in the same direction to the same degree) and minus one, which means they are perfectly negatively correlated (in that they move in opposite directions to thesame degree). In financial markets correlation is important in three areas: 1. The model used for global asset allocation decisions, Sharpe’s capital asset pricing model (CAPM), has, as its linch pin,a covariance matrix that measures correlations between markets. 2. Correlation is also central to the pricing of some options, where two-factor or multi-factor models are used. For spread options, yield curve options and crosscurrency caps, estimating the correlation between the underlying assets is of primary importance, the degree of correlation between them having a direct influence on the option price. For quantos such as guaranteed exchange rate options, or differential swaps, the correlation effect is the extent to which there is a relationship between movements in the underlying and movements in the exchange rate, which has a secondary effect on the price of the option. 3. Correlation between markets is also used to offset an option position in one market against another with similar direction and volatility. Such a strategy might be used to reduce cost – to avoid hedging the positions separately, or because implied volatility in the second market is lower – or because hedging is difficult in the first market. Correlation can be estimated historically (like volatility) but tends to be unstable, and historic estimations may be poor predictors of future realised correlations.
