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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 Carr and Lee (2008) 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 nonzero. In this paper, we show that the correlation immunization strategy is the only strategy among the class of strategies discussed in Carr and Lee (2008) that results in real-valued hedging portfolios when the correlation between the asset's price and volatility is nonzero. 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 nonzero correlation.

Suggested Citation

  • Jimin Lin & Matthew Lorig, 2018. "On Carr and Lee's correlation immunization strategy," Papers 1809.10256, arXiv.org, revised Mar 2019.
    • Handle: RePEc:arx:papers:1809.10256
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    References listed on IDEAS

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    1. Heston, Steven L, 1993. "A Closed-Form Solution for Options with Stochastic Volatility with Applications to Bond and Currency Options," The Review of Financial Studies, Society for Financial Studies, vol. 6(2), pages 327-343.
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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.
    2. Giertz, Jan-Paul & Stracke, Stefan, 2019. "Strategische Personalplanung: Praxiswissen Betriebsvereinbarungen," Study / edition der Hans-Böckler-Stiftung, Hans-Böckler-Stiftung, Düsseldorf, volume 127, number 433, March.

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