[ 2009 FRM Sample Exam ] Market risk measurement and management Q26 determine, management, positive, between, impact

Babul

 

26. You are long a call option on a spread. The payout is equal to max(F1 ? F2 , 0). The correlation between F1 and F2 is positive. What is the impact on the option value if the correlation declines toward zero?

A. The option value increases.

B. The option value remains the same.

C. The option value decreases.

D. It is impossible to determine.

Babul

 

Correct answer is Afficeffice" />

This question tests understanding of option value drivers.  The payoff of this option is driven by the volatility of the spread between F1 and F2 which depends upon the correlation between F1 and F2.  As correlation declines toward 0 the spread volatility increases therefore the option value increases. Thus B, C, and D are all wrong.

Reference: ffice:smarttags" />Hull, Options Futures and Other Derivatives, 4th Edition, section 18.5

Question Type: Market Risk