Option-Implied Correlations and the Price of Correlation Risk

48 Pages Posted: 26 Nov 2013

See all articles by Joost Driessen

Joost Driessen

Tilburg University - Center and Faculty of Economics and Business Administration; Tilburg University - Center for Economic Research (CentER)

Pascal J. Maenhout

INSEAD - Finance

Grigory Vilkov

Frankfurt School of Finance & Management

Multiple version iconThere are 2 versions of this paper

Date Written: July 26, 2013

Abstract

Motivated by extensive evidence that stock-return correlations are stochastic, we analyze whether the risk of correlation changes (affecting diversification benefits) may be 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 stock market returns, which also stays significant after controlling for a number of fundamental market return predictors.

Suggested Citation

Driessen, Joost and Maenhout, Pascal J. and Vilkov, Grigory, Option-Implied Correlations and the Price of Correlation Risk (July 26, 2013). Netspar Discussion Paper No. 07/2013-061. Available at SSRN: https://ssrn.com/abstract=2359380 or http://dx.doi.org/10.2139/ssrn.2359380

Joost Driessen (Contact Author)

Tilburg University - Center and Faculty of Economics and Business Administration ( email )

P.O. Box 90153
Tilburg, 5000 LE
Netherlands

Tilburg University - Center for Economic Research (CentER) ( 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

Frankfurt School of Finance & Management ( email )

Adickesallee 32-34
Frankfurt am Main, 60322
Germany

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

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