correlation risk !?

[narayananvenkat]

David..

A portfolio manager has a $ 15 million mid-cap portfolio that has a beta of 1.3 relative to S&P 400. S&P 500 futures are trading at 1150 and have a multiplier of 250. The most significant risk this manager faces in attempting tohedge his position is:

I. correlation risk resulting from a rollover of positions between S&p 400 and S&P 500.

II. Volatility risk arising from instable correlation predictios

III. basis risk resulting from a cross hedge.

IV. Improper profit forecasts of underlying position.

Well, the manager seems to look for a cross hedge and hence exisitence of basis risk is obvious.
But what is the correlation risk per se as well as relevant here.
Also what is the volatility of correlation ?

venkat

 

[David Harper CFA FRM]

Hi venkat,

Choice (I) is strange to me, maybe it's "false answer" mumbo-jumbo? In hedging with futures, the manager may need to rollover contracts but I don't think we'd assume that's much of a risk for liquid contracts (per the MG case study, there is always a risk of negative roll return: contango will produce negative roll return...but this seem unrelated...)

Choice (II) is very awkward language for FRM (it's as if from a diferent exam), but it has a very valid idea: the beta will vary over time. Here the hedge is based on beta of 1.5, probably inferred from historical data. But if, going forward, the realtionship between forward and spot changes, this is tantamount to *unexpected* basis strengthening or weakening, which "breaks" the hedge. And, please note beta = Covariance (future, spot) / Variance (spot) = correlation * volatility (future) * volatilility (spot). In short, beta is very near to correlation, beta = correlation * "cross-volatility" ... so I might re-phrase Choice (II) into more typical "FRM language:"

* Risk that beta (~correlation") is time-varying (~ volatiltiy)

...and then, I would have a hard time selecting between (I) and (II) because arguably (II) subsumes (I) ....both are significant risks.

David