What is correlation risk in dispersion trading?

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AcadiFi · Accepted Answer

Dispersion trading sells index volatility (SPX options) and buys single-stock volatility on constituents, profiting when realized correlation among constituents is lower than implied. The index variance equals a correlation-weighted sum of single-name variances: sigma_idx^2 = sum(w_i^2 * sigma_i^2) + 2*sum(w_i*w_j*rho_ij*sigma_i*sigma_j). When correlation drops, index vol drops faster than single-name vols, making the spread profitable. For an index-to-30-names dispersion on a large-cap portfolio, you might short SPX variance swap at 18 and long a vega-weighted basket of 30 single-stock variance swaps averaging 25. The implied correlation embedded = (sigma_idx^2 - sum(w_i^2*sigma_i^2)) / (2*sum of cross terms with rho=1) might be 0.55. If realized correlation comes in at 0.42, the trade profits. The risk: correlation spikes in market stress. In March 2020, implied correlation jumped from 0.40 to 0.85 in two weeks, crushing dispersion books. Hedges include buying correlation swaps outright, VIX calls (correlation spikes with vol), or reducing leverage before known catalysts. ```mermaid graph TD A[Short index
variance] --> C[Dispersion
P&L] B[Long singles
variance] --> C C --> D[Profits when
corr falls] ```

What is correlation risk in dispersion trading?

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