Is the information obtained from European options on equally weighted baskets enough to determine the prices of exotic derivatives such as worst-of options?
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In recent years there has been a remarkable growth of multi-asset options. These options exhibit sensitivity to the volatility of the underlying assets, as well as to their correlations. The call versus call is a product commonly used to trade correlation within the inter-dealer broker markets. The buyer of correlation buys a European call on the equally weighted basket option and sells a weighted average of European calls on each asset. In this case, the following important question arises: Is the information provided by equally weighted basket options enough to price other European multi-asset exotic derivatives such as worst-of or outperformance options? This article investigates this issue under a stochastic correlation framework. Importantly, this article shows that, when pricing multi-asset exotic derivatives, matching the prices of European equally weighted basket options, quoted in the market, does not guaranty the absence of model risk even in the case where the exotic payoff is observed only at maturity.
KeywordsStochastic correlation Stochastic volatility Multifactor Worst-of options Outperformance options Equally weighted basket options
JEL ClassificationG1 G2 G12 G13
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