Option-Implied Correlations, Factor Models, and Market Risk
53 Pages Posted: 27 Jan 2017 Last revised: 8 Mar 2017
Date Written: November 1, 2016
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: Suggested Citation