We are independent & ad-supported. We may earn a commission for purchases made through our links.
Advertiser Disclosure
Our website is an independent, advertising-supported platform. We provide our content free of charge to our readers, and to keep it that way, we rely on revenue generated through advertisements and affiliate partnerships. This means that when you click on certain links on our site and make a purchase, we may earn a commission. Learn more.
How We Make Money
We sustain our operations through affiliate commissions and advertising. If you click on an affiliate link and make a purchase, we may receive a commission from the merchant at no additional cost to you. We also display advertisements on our website, which help generate revenue to support our work and keep our content free for readers. Our editorial team operates independently of our advertising and affiliate partnerships to ensure that our content remains unbiased and focused on providing you with the best information and recommendations based on thorough research and honest evaluations. To remain transparent, we’ve provided a list of our current affiliate partners here.
Finance

Our Promise to you

Founded in 2002, our company has been a trusted resource for readers seeking informative and engaging content. Our dedication to quality remains unwavering—and will never change. We follow a strict editorial policy, ensuring that our content is authored by highly qualified professionals and edited by subject matter experts. This guarantees that everything we publish is objective, accurate, and trustworthy.

Over the years, we've refined our approach to cover a wide range of topics, providing readers with reliable and practical advice to enhance their knowledge and skills. That's why millions of readers turn to us each year. Join us in celebrating the joy of learning, guided by standards you can trust.

What Is a Correlation Swap?

John Lister
By
Updated: May 16, 2024

A correlation swap is a particularly complicated form of financial derivative that is not based directly on the price of an underlying asset. Instead it is based on the relationship between the prices of two or more assets. Because of this complexity, a correlation swap must be arranged privately and is not available through mainstream financial exchanges.

The basic form of derivative is comparatively simple. The derivative is an asset in itself, but it derives its value from a separate underlying asset. A simple example is a futures contract, in which one party agrees to buy a set amount of a stock at a set price on a set future date from the second party. This may prove a good or bad deal depending on the market price of the stock on the agreed completion date: if the market price is higher, the buyer of the stock can immediately sell at a profit. Because a futures contract is an asset in itself, the buying party can sell on the rights to complete the deal before it comes due. This is known as selling a position.

A swap derivative goes one step further as it is based on two or more underlying assets, one from each party in the agreement. It involves the two sides agreeing to swap the revenue from the respective assets. For example, in a bond swap, the two sides each own a bond, but agree to swap any coupon payments they receive from their bond. In effect, the two sides swap the risk involved in their own asset, for example, the risk that a bond issuer may not pay the expected coupon payment. Such deals can be done purely as speculation, or they may be used to mitigate risk, a tactic known as hedging.

The correlation swap is based on the correlation between two assets on a future date, not the price. For example, the first party in the deal may predict that the stock price of company A may be twice the stock price of company B in three months, and pay a flat amount to the second party. In return, in three months, the second party will pay a variable amount that depends on the actual correlation. For example, if the stock price of company A turns out to be three times the stock price of company B on that date, the second party may have to pay a larger amount back to the first party.

The correlation swap process is relatively complicated as those involved not only have to predict how each price will change, but also the comparative changes of the two. In turn, this makes it much more difficult to figure out a fair price for buying or selling a position in the deal. At the moment, there aren't any formulas that are widely accepted as giving an accurate and fair valuation in a way that cuts out the possibility of arbitrage. This is where a trader can exploit differences in pricing between two deals, such as two correlation swap agreements, to greatly increase the likelihood of making a profit, or even make doing so theoretically certain.

SmartCapitalMind is dedicated to providing accurate and trustworthy information. We carefully select reputable sources and employ a rigorous fact-checking process to maintain the highest standards. To learn more about our commitment to accuracy, read our editorial process.
John Lister
By John Lister
John Lister, an experienced freelance writer, excels in crafting compelling copy, web content, articles, and more. With a relevant degree, John brings a keen eye for detail, a strong understanding of content strategy, and an ability to adapt to different writing styles and formats to ensure that his work meets the highest standards.
Discussion Comments
John Lister
John Lister
John Lister, an experienced freelance writer, excels in crafting compelling copy, web content, articles, and more. With...
Learn more
Share
SmartCapitalMind, in your inbox

Our latest articles, guides, and more, delivered daily.

SmartCapitalMind, in your inbox

Our latest articles, guides, and more, delivered daily.