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The price of correlation risk: Evidence from equity options
| Venue: | Journal of Finance, 64(3):1377 |
| Citations: | 38 - 5 self |
BibTeX
@ARTICLE{Driessen_theprice,
author = {Joost Driessen and Pascal J. Maenhout and Grigory Vilkov and Toby Moskowitz and Anthony Neuberger and Josh Rosenberg and Mark Rubinstein and Pedro Santa-clara},
title = {The price of correlation risk: Evidence from equity options},
journal = {Journal of Finance, 64(3):1377},
year = {}
}
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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 indi-vidual 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, provid-ing 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 ev-idence that correlations between asset returns change over time1 and that stock return correlations increase when returns are low.2 A marketwide increase in correlations negatively affects investor welfare by lowering diversification ben-efits and by increasing market volatility, so that states of nature with unusually high correlations may be expensive. It is therefore natural to ask whether mar-ketwide 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
Keyphrases
correlation risk equity option stock return correlation increase stock return market volatility financial market correlation play central role correlation risk premium cannot diversification ben-efits option return correlation shock high correlation high price trading strategy marketwide increase realistic trading friction crra investor high alpha marketwide correlation limits-to-arbitrage interpretation individual option return investor welfare p100 index option considerable ev-idence correlation risk exposure indi-vidual variance risk asset return mar-ketwide correlation risk
