ABSTRACT
Even without a model, we have a sense of correlation using statistical measures, i.e., by looking at historical data, and for many investment applications, this intuitive understanding is sufficient. However, recent product development has enabled the extraction of implied correlation using correlation-sensitive traded securities. The implied correlation approach adopts the risk-neutral pricing framework, and makes strong assumptions about the liquidity and risk-premium content, as well as the distributional characteristics of assets. We should note that the expected loss on straight portfolio products or baskets is not sensitive to changes in correlations, so tranches or other correlation-sensitive securities are required to extract any implied correlation content.
