Jumping Off the Bandwagon: Introducing Jumps to Equity Correlation

Abstract

The goal of this paper is to anchor a stochastic correlation model into the real-world multi-underlying equity derivatives, providing the relevant instruments to which it should be calibrated and discussing the ones affected by it. We specifically look for a self-consistent mechanism to generate the implied correlation skew. We start with correlation model based on the Jacobi process. In order to reach the steep short term index skew we extend it by adding jumps in correlation. The model thus obtained could constitute the link between dispersion trades and worst-of options. Going a step further, the model could serve as a vehicle for transferring the correlation skew information between different baskets.