Correlation Risk, Strings and Asset Prices

48 Pages Posted: 2 Aug 2019

See all articles by Walter Distaso

Walter Distaso

Imperial College Business School

Antonio Mele

USI Università della Svizzera italiana; Swiss Finance Institute; Centre for Economic Policy Research (CEPR)

Grigory Vilkov

Frankfurt School of Finance & Management

Date Written: July 2019

Abstract

Standard asset pricing theories treat return volatility and correlations as two intimately related quantities, which hinders achieving a neat definition of a correlation premium. We introduce a model with a continuum of securities that have returns driven by a string. This model leads to new arbitrage pricing restrictions, according to which, holding any asset requires compensation for the granular exposure of this asset returns to changes in all other asset returns: an average correlation premium. We find that this correlation premium is both statistically and economically significant, and considerably fluctuates, driven by time-varying correlations and global market developments. The model explains the cross-section of expected returns and their counter-cyclicality without making reference to common factors affecting asset returns. It also explains the time-series behavior of the premium for the risk of changes in asset correlations (the correlation-risk premium), including its inverse relation with realized correlations.

Keywords: arbitrage pricing, correlation premium, correlation-risk premium, cross-section of returns, implied correlation, string models

JEL Classification: G11, G12, G13, G17

Suggested Citation

Distaso, Walter and Mele, Antonio and Vilkov, Grigory, Correlation Risk, Strings and Asset Prices (July 2019). CEPR Discussion Paper No. DP13873. Available at SSRN: https://ssrn.com/abstract=3428397

Walter Distaso (Contact Author)

Imperial College Business School ( email )

South Kensington Campus
Exhibition Road
London SW7 2AZ, SW7 2AZ
United Kingdom

Antonio Mele

USI Università della Svizzera italiana ( email )

Via Buffi 13
Lugano, 6900
Switzerland

HOME PAGE: http://antoniomele.org

Swiss Finance Institute

c/o University of Geneva
40, Bd du Pont-d'Arve
CH-1211 Geneva 4
Switzerland

Centre for Economic Policy Research (CEPR) ( email )

London
United Kingdom

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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