The Price of Correlation Risk: Evidence from Equity Options

Abstract

We study whether exposure to marketwide correlation shocks affects expected option returns, using data on S&P100 index options, options on all components, and stock returns. We find 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 finding of a high price of correlation risk.CORRELATIONS PLAY A CENTRAL ROLE in financial markets. There is considerable evidence that correlations between asset returns change over time 1 and that stock return correlations increase when returns are low. 2 A marketwide increase in correlations negatively affects investor welfare by lowering diversification benefits and by increasing market volatility, so that states of nature with unusually high correlations may be expensive. It is therefore natural to ask whether marketwide correlation risk is priced in the sense that assets that pay off well when marketwide correlations are higher than expected (thereby providing a * Driessen is at the University of Amsterdam. Maenhout and Vilkov are at INSEAD. We would like to thank Yacine Aït-Sahalia, David Bates, Jonathan Berk, Oleg Bondarenko, Michael Brandt, Menachem Brenner, John Campbell, Mike Chernov, Greg Duffee, Darrell Duffie, Rob Engle, Jan Ericsson, Gerard Gennotte, Jens Jackwerth, Chris Jones, Frank de Jong, Hayne Leland, Toby Moskowitz, Anthony Neuberger, Josh Rosenberg, Mark Rubinstein, Pedro Santa-Clara, Ken Singleton, Otto van Hemert, Robert Whitelaw, Zhipeng Zhang, and especially Bernard Dumas for comments and stimulating discussions. We are particularly grateful for the detailed and constructive comments of an anonymous referee and the Editor. We received helpful comments from seminar participants at Berkeley Haas School of Business, BI Oslo, Cornell Johnson School, HEC Lausanne, INSEAD, LBS-LSE-Oxford Asset Pricing Workshop, MIT Sloan, NY Fed, NYU Stern, Stanford GSB, Tilburg,

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A latent dynamic factor approach to forecasting multivariate stock market volatility

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Firm-Specific Risk-Neutral Distributions: The Role of CDS Spreads

“…We find that our results are robust to a large set of asset pricing fac-1 A partial list of studies on extracting option-implied distributions for equity indexes includes Bates (1991), Madan and Milne (1994), Rubinstein (1994), Longstaff (1995), Jackwerth and Rubinstein (1996), Aït-Sahalia and Lo (1998), Bates (2000), Bliss and Panigirtzoglou (2002), Figlewski (2010), Birru and Figlewski (2012), and Andersen, Fusari, and Todorov (2015). Investors are net buyers of index options (Gârleanu, Pedersen, and Poteshman, 2009), and index options trade with more out-of-the-money (OTM) strikes than single-stock options since they provide hedge against increases in correlation that reduce the benefits of diversification (see Driessen, Maenhout, and Vilkov, 2009). tors, stock characteristics, and different assumptions about key inputs of the method, such as CDS tenor and default thresholds.…”