AppliedMultiple choice
Two stocks and a worst-of · Part 2 of 3
Two stocks each trade at $100 with 30% volatility. A one-year worst-of call pays the larger of zero and the worse-performing stock’s return. The correlation between the stocks is 0.5.
If the correlation rises from 0.5 towards 1, what happens to the worst-of call’s value, and so to a desk that has sold it?
- AIt rises, so the desk loses
- BIt falls, so the desk gains, since higher correlation means less diversification
- CIt is unchanged, because each stock’s volatility has not moved
- DIt falls to zero, since perfectly correlated stocks can never both rise
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