Correlation Basics: Definitions, Applications, and Terminology (FRM Part 2 – Book 1 – Chapter 7)

Understand correlation from an FRM (Financial Risk Manager) perspective.
In this lesson from FRM Part 2 – Book 1: Market Risk Measurement and Management, we break down correlation risk, why correlations spike during crises, and how derivatives (correlation swaps, rainbow options, quanto options) are used to trade or hedge correlation.

What you’ll learn:
What correlation risk is in financial markets
How correlations contributed to the Global Financial Crisis (2007-2009)
Why diversification fails when correlations rise
How to calculate covariance and correlation
Two-asset portfolio risk and the role of co-movement
Correlation swaps, rainbow options, quanto options
-How correlation affects Value at Risk (VaR)

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After completing this reading you should be able to:
Describe financial correlation risk and the areas in which it appears in finance.
Explain how correlation contributed to the global financial crisis of 2007 to 2009.
Describe the structure, uses, and payoffs of a correlation swap.
Estimate the impact of different correlations between assets in the trading book on the VaR capital charge.
Explain the role of correlation risk in market risk and credit risk.
Relate correlation risk to systemic and concentration risk.

0:00 Introduction
0:31 Learning Outcomes
1:08 Financial Correlation Risk
12:00 Risk of a Two-asset Portfolio
15:54 Interpreting Covariance
21:55 Interpreting the Return/Risk Ratio
28:44 Multi-Asset Options
29:55 Quanto Option
30:41 Correlation Swaps
35:30 How else can Investors Buy Correlation?
38:55 Impact of Different Correlations on the VaR Capital Charge
44:30 Regulation and Correlation
46:06 How Correlation Contributed to the Global Financial Crisis of 2007 to 2009
47:28 Correlation Risk in Market Risk and Credit Risk Correlation Risk and Market Risk
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