Option-Implied Correlations, Factor Models, and Market Risk

53 Pages Posted: 27 Jan 2017 Last revised: 8 Mar 2017

See all articles by Adrian Buss

Adrian Buss

Frankfurt School of Finance & Management; Centre for Economic Policy Research (CEPR)

Lorenzo Schoenleber

Collegio Carlo Alberto

Grigory Vilkov

Frankfurt School of Finance & Management

Date Written: November 1, 2016

Abstract

Implied correlation and variance risk premium stand out in predicting market returns. However, while the predictive ability of implied correlation lasts for up to a year, the variance risk premium predicts market returns only for one quarter ahead. Contrary to the accepted view, implied correlation predicts the market return not through a diversification risk (average correlation) channel, but by predicting a concentration of market exposure, which defines the level of non-diversifiable market risk, or systematic diversification. Economy-wide implied correlation built exclusively from option prices of nine sector ETFs and the S&P500 efficiently predicts future market returns and systematic diversification risk in the form of market betas dispersion. Newly developed implied correlations for economic sectors provide industry-related information and are used to extract option-implied risk factors from sector-based covariances.

Keywords: Implied Correlation, Factor Model, Market Factor, Factor Exposure, VIX, ETF, Sectors

JEL Classification: G11, G12, G13, G17

Suggested Citation

Buss, Adrian and Schönleber, Lorenzo and Vilkov, Grigory, Option-Implied Correlations, Factor Models, and Market Risk (November 1, 2016). INSEAD Working Paper No. 2017/20/FIN, Available at SSRN: https://ssrn.com/abstract=2906484 or http://dx.doi.org/10.2139/ssrn.2906484

Adrian Buss

Frankfurt School of Finance & Management ( email )

Adickesallee 32-34
Frankfurt, 60322
Germany

Centre for Economic Policy Research (CEPR) ( email )

London
United Kingdom

Lorenzo Schönleber

Collegio Carlo Alberto ( email )

Piazza Vincenzo Arbarello, 8
Torino, Torino 10122
Italy

HOME PAGE: http://https://www.carloalberto.org/person/lorenzo-schoenleber/

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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