Option-Implied Dependence and Correlation Risk Premium
49 Pages Posted: 19 Jun 2020 Last revised: 1 Jul 2021
Date Written: February 1, 2021
We propose a novel model-free approach to obtain the joint risk-neutral distribution among several assets that is consistent with options on these assets and their weighted index. We implement this approach for the nine industry sectors comprising the S&P 500 index and find that their option-implied dependence is highly asymmetric and time-varying. We then study two conditional correlations: when the market moves down or up. The risk premium is strongly negative for the down correlation but positive for the up correlation. Intuitively, investors dislike the loss of diversification when markets fall, but they actually prefer high correlation when markets rally.
Keywords: Model-Free Dependence, Implied Correlations, Forward-Looking Dependence, Down and up Correlation, Correlation Risk Premium
JEL Classification: G11, G12, G13, G17
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