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On Carr and Lee’s Correlation Immunization Strategy

Author

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  • Jimin Lin
  • Matthew Lorig

Abstract

In their seminal work Robust Replication of Volatility Derivatives, Carr and Lee show how to robustly price and replicate a variety of claims written on the quadratic variation of a risky asset under the assumption that the asset’s volatility process is independent of the Brownian motion that drives the asset’s price. Additionally, they propose a correlation immunization strategy that minimizes the pricing and hedging error that results when the correlation between the risky asset’s price and volatility is non-zero. In this paper, we show that the correlation immunization strategy is the only strategy among the class of strategies discussed in Carr and Lee's paper that results in real-valued hedging portfolios when the correlation between the asset’s price and volatility is non-zero. Additionally, we perform a number of Monte Carlo experiments to test the effectiveness of Carr and Lee’s immunization strategy. Our results indicate that the correlation immunization method is an effective means of reducing pricing and hedging errors that result from a non-zero correlation.

Suggested Citation

  • Jimin Lin & Matthew Lorig, 2019. "On Carr and Lee’s Correlation Immunization Strategy," Applied Mathematical Finance, Taylor & Francis Journals, vol. 26(2), pages 131-152, March.
    • Handle: RePEc:taf:apmtfi:v:26:y:2019:i:2:p:131-152
    DOI: 10.1080/1350486X.2019.1598276
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    Cited by:

    1. Peter Carr & Roger Lee & Matthew Lorig, 2021. "Robust replication of volatility and hybrid derivatives on jump diffusions," Mathematical Finance, Wiley Blackwell, vol. 31(4), pages 1394-1422, October.

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