Measuring Equity Risk with Option-Implied Correlations

39 Pages Posted: 16 Nov 2008 Last revised: 27 Dec 2012

See all articles by Adrian Buss

Adrian Buss

INSEAD - Finance; Centre for Economic Policy Research (CEPR)

Grigory Vilkov

Frankfurt School of Finance & Management

Date Written: May 31, 2012

Abstract

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

Buss, Adrian and Vilkov, Grigory, Measuring Equity Risk with Option-Implied Correlations (May 31, 2012). EFA 2009 Bergen Meetings Paper. Available at SSRN: https://ssrn.com/abstract=1301437 or http://dx.doi.org/10.2139/ssrn.1301437

Adrian Buss

INSEAD - Finance ( email )

Boulevard de Constance
Fontainebleau Cedex, 77305
France
+33 160 72 44 84 (Phone)
+33 160 72 40 45 (Fax)

HOME PAGE: http://sites.google.com/view/abuss

Centre for Economic Policy Research (CEPR) ( email )

London
United Kingdom

Grigory Vilkov (Contact Author)

Frankfurt School of Finance & Management ( email )

Adickesallee 32-34
Frankfurt am Main, 60322
Germany

HOME PAGE: http://www.vilkov.net

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