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Option-Implied Correlations and the Price of Correlation Risk

47 Pages Posted: 26 Oct 2012 Last revised: 19 Apr 2016

Joost Driessen

Tilburg University - Department of Finance; CentER Tilburg University

Pascal J. Maenhout

INSEAD - Finance

Grigory Vilkov

Frankfurt School of Finance & Management

Multiple version iconThere are 2 versions of this paper

Date Written: October 01, 2005

Abstract

Motivated by extensive evidence that stock-return correlations are stochastic, we analyze whether the risk of correlation changes (affecting diversification benefits) is priced. We propose a direct and intuitive test by comparing option-implied correlations between stock returns (obtained by combining index option prices with prices of options on all index components) with realized correlations. Our parsimonious model shows that the substantial gap between average implied (39.5% for S&P500 and 46.0% for DJ30) and realized correlations (32.5% and 35.5%, respectively) is direct evidence of a large negative correlation risk premium. Empirical implementation of our model also indicates that the index variance risk premium can be attributed to the high price of correlation risk. Finally, we provide evidence that option-implied correlations have remarkable predictive power for future market returns, which also stays significant after controlling for a number of fundamental market return predictors.

Keywords: implied correlation, return predictability, index variance, variance risk premium, individual options

JEL Classification: G11, G12, G13, G17

Suggested Citation

Driessen, Joost and Maenhout, Pascal J. and Vilkov, Grigory, Option-Implied Correlations and the Price of Correlation Risk (October 01, 2005). Advanced Risk & Portfolio Management Paper. Available at SSRN: https://ssrn.com/abstract=2166829 or http://dx.doi.org/10.2139/ssrn.2166829

Joost Driessen

Tilburg University - Department of Finance ( email )

P.O. Box 90153
Tilburg, 5000 LE
Netherlands

CentER Tilburg University ( email )

P.O. Box 90153
Tilburg, 5000 LE
Netherlands

Pascal J. Maenhout

INSEAD - Finance ( email )

Boulevard de Constance
F-77305 Fontainebleau Cedex
France

Grigory Vilkov (Contact Author)

Frankfurt School of Finance & Management ( email )

Sonnemannstraße 9-11
Frankfurt am Main, 60314
Germany

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

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