The Price of Correlation Risk: Evidence from Equity Options

60 Pages Posted: 25 Feb 2005 Last revised: 14 Jul 2008

See all articles by Joost Driessen

Joost Driessen

Tilburg University - Center and Faculty of Economics and Business Administration; Tilburg University - Center for Economic Research (CentER)

Pascal J. Maenhout

INSEAD - Finance

Grigory Vilkov

Frankfurt School of Finance & Management

Date Written: December 2006

Abstract

We study whether exposure to market-wide correlation shocks affects expected option returns, using data on S&P100 index options, options on all components, and stock returns. We present evidence of priced correlation risk based on prices of index and individual variance risk. A trading strategy exploiting priced correlation risk generates a high alpha and is attractive for CRRA investors without frictions. Correlation risk exposure explains the cross-section of index and individual option returns well. The correlation risk premium cannot be exploited with realistic trading frictions, providing a limits to arbitrage interpretation of our ýndings of a high price of correlation risk.

Keywords: Correlation risk, Dispersion trading, Index volatility, Stochastic volatility, Expected option returns

JEL Classification: G13

Suggested Citation

Driessen, Joost and Maenhout, Pascal J. and Vilkov, Grigory, The Price of Correlation Risk: Evidence from Equity Options (December 2006). EFA 2005 Moscow Meetings. Available at SSRN: https://ssrn.com/abstract=673425 or http://dx.doi.org/10.2139/ssrn.673425

Joost Driessen

Tilburg University - Center and Faculty of Economics and Business Administration ( email )

P.O. Box 90153
Tilburg, 5000 LE
Netherlands

Tilburg University - Center for Economic Research (CentER) ( email )

P.O. Box 90153
Tilburg, 5000 LE
Netherlands

Pascal J. Maenhout

INSEAD - Finance ( email )

Boulevard de Constance
F-77305 Fontainebleau Cedex
France

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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