Basket Options: Correlation and Volatility

There are a number of key determinants that have to be looked at when pricing basket options and we discuss two of the more important factors here; volatility and correlation. Volatility has a positive effect on basket option value, with higher volatility meaning a higher price. The value of a basket option also depends on the degree of correlation between the assets in the basket or portfolio. We look at examples of incorporating volatility and correlation, and then conclude by illustrating the relationship between the two.