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J. Driessen, P. Maenhout, and G. Vilkov, “The Price of Correlation Risk: Evidence from Equity Options,” Journal of Finance, June 2010.

J. Driessen, P. Maenhout, and G. Vilkov, “The Price of Correlation Risk: Evidence from Equity Options,” Journal of Finance, June 2010.

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 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. Copyright (c) 2009 The American Finance Association.