Measuring Equity Risk with Option-Implied Correlations
39 Pages Posted: 16 Nov 2008 Last revised: 27 Dec 2012
Date Written: May 31, 2012
We use forward-looking information from option prices to estimate option-implied correlations and to construct an option-implied predictor of factor betas. With our implied market betas, we find a monotonically increasing risk-return relation, not detectable with standard rolling-window betas, with the slope close to the market excess return. Our implied betas confirm a risk-return relation consistent with linear factor models, because, when compared to other beta approaches: (i) they are better predictors of realized betas, and (ii) they exhibit smaller and less systematic prediction errors. The predictive power of our betas is not related to known relations between option-implied characteristics and returns.
Keywords: option-implied, correlation, beta, risk-return relation, CAPM, factor models, pairs trading
JEL Classification: G11, G12, G14, G17
Suggested Citation: Suggested Citation