The risk that arises in many types of exotic options (particularly, multi-asset options, basket options, etc.) A correlation risk is commonplace in situations where an option has an underlying basket of stocks or its payoff is contingent on the future evolution of a selected number of stocks or other assets. The unfavorable correlation between the prices of underlying asset gives rise to such a risk. The correlation risk impacts the price of an option in two ways, depending on its payoff structure: it affects the volatility of the basket of underlying assets and also the dispersion of the single assets within the basket.
The value/ price of a basket option is affected only by the basket volatility, while it is not impacted by the dispersion of individual assets, because the payoff is determined based on the totaled asset prices at maturity. Basket volatility (and hence the option price) increases in reaction to an increase in basket volatility.
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