Downside Implied Correlation: The Driving Force of Volatility Risk

Abstract

We introduce a novel decomposition of aggregate market variance into average downside and upside variances and correlations. Average downside implied correlation drives volatility risk pricing in the cross-section of stock returns. Stocks with high exposure to downside correlation risk earn annual returns 7.30% lower than those with low exposure, consistent with these stocks providing insurance against diversification risk. Our findings show that downside correlation risk represents a more fundamental driver of the risk premium associated with diversification risk than previously identified factors. Mean-variance investors can achieve substantial economic gains by including the average downside correlation factor into their optimization framework.

Keywords: Diversification risk, Implied correlation risk, Volatility risk, Downside risk, Cross-section of stock returns

JEL Classification: G11, G12, G13