How much a control variate helps

You price a derivative by Monte Carlo (payoff XX) and use a control variate YY with a known mean — you subtract off β(YE[Y])\beta(Y - E[Y]) using the optimal coefficient β\beta^\star. You measure Var(X)=25\operatorname{Var}(X) = 25, Var(Y)=9\operatorname{Var}(Y) = 9, and Cov(X,Y)=9\operatorname{Cov}(X, Y) = 9. After applying the optimal control variate, what fraction of the original variance Var(X)\operatorname{Var}(X) still remains? Give it to four decimals.

Show hints (2)+
  1. The optimal control variate leaves the regression residual: a fraction 1ρ21-\rho^2 of the original variance.
  2. ρ=Cov/Var(X)Var(Y)=9/15\rho = \operatorname{Cov}/\sqrt{\operatorname{Var}(X)\operatorname{Var}(Y)} = 9/15; the question asks the fraction remaining, not the cut.

Answer

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0.64 (± 0.001)

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Asked at: Citadel, Two Sigma

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