Abstract
It is well known that implied correlation smile effects have a large impact on the pricing of multi-asset derivatives. However, in practice, the effects are usually ignored because of a perception that the modelling problem is too hard. In this talk I first look at the meaning of the implied correlation smile, and then introduce a taxonomy of models capable of exactly re-pricing correlation smiles. These include analytic or semi-analytic models for “flow” products, through to full dynamic local-stochastic correlation models for path dependent trades. By introducing the concept of numeraire symmetry, we can classify models into “good” and “bad” and draw some shocking conclusions about the multi-asset models that are widely in use today.
[PDF] Slides of the talk.