Explain the Role of “Correlation Risk” in the Pricing of Basket Options

A basket option is a derivative whose payoff depends on the performance of a portfolio (basket) of underlying assets. Correlation risk is the risk that the actual correlation between the assets in the basket deviates from the correlation assumed in the pricing model.

Since correlation is a key input, any misestimation can lead to significant mispricing. To protect against this uncertainty, market makers widen the bid-ask spread, which increases the slippage for the buyer.