Finding a Valid FX Covariance Matrix in the BS World

Abstract

A number of methods has already been proposed for creating a valid correlation matrix in finance. However, such methods do not normally take into account additional restrictions on matrix elements imposed by specific non-arbitrage conditions in some markets, e.g. foreign exchange (FX). I suggest that taking those restrictions, known as triangular relationships, into account can lead to a more efficient method of correction of invalid correlation matrices, at least in FX markets. This paper outlines the steps of the new method.