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Answer: Investors can take a synthetic long position in equity correlation by buying put options on an equity index and selling put options on the components of that index.
## Explanation **B is correct.** Investors can indeed take a synthetic long position in equity correlation by buying put options on an equity index and selling put options on the components of that index. This strategy profits when correlation increases because the index put options become more valuable relative to the individual stock put options. **A is incorrect.** The payoff for these correlation-sensitive products is NOT highest when price movements are uncorrelated. For rainbow options and correlation swaps, the payoff is typically highest when price movements are either completely positively correlated or completely negatively correlated, depending on the specific product structure. **C is incorrect.** The payoff for the correlation buyer in a correlation swap is POSITIVE (not negative) if the realized correlation is higher than the fixed correlation in the swap. The buyer benefits from higher-than-expected correlation. **D is incorrect.** The London Whale (JPMorgan trader Bruno Iksil) actually traded correlation synthetically by selling index credit default swaps (CDSs) and purchasing CDSs on individual bonds, not by purchasing index swaps. The losses occurred when hedge funds executed a "short squeeze" against his positions. This question tests understanding of correlation trading strategies and the characteristics of various correlation-sensitive derivatives.
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The manager of the equity trading desk of an investment bank is presenting to a group of newly hired analysts on complex derivatives the desk uses to take positions on equity correlations. The manager discusses characteristics and uses of rainbow options, quanto options, and correlation swaps, and demonstrates how the payoff of each product can be modeled with examples that use the Dow Jones Industrial Average as the underlying asset for each instrument. Which of the following statements could the manager correctly make during the presentation?
A
The payoff for each of these products is highest when the price movements of the underlying assets are uncorrelated.
B
Investors can take a synthetic long position in equity correlation by buying put options on an equity index and selling put options on the components of that index.
C
The payoff for the correlation buyer in a correlation swap is negative if the realized correlation of the underlying assets is higher than the fixed correlation in the swap.
D
The trader known as the London Whale created large losses by continuing to purchase index swaps even when losses from earlier positions continued to increase.