A. Buss and G. Vilkov: Measuring Equity Risk with Option-Implied Correlations

February 20, 2012

We use forward-looking information from option prices to estimate option-implied correlations and to construct an option-implied predictor of factor betas. With our implied market betas, we find a monotonically increasing risk-return relation, not detectable with standard rolling-window betas, with the slope close to the market excess return. Our implied betas confirm a risk-return relation consistent with linear factor models, because, when compared to other beta approaches: (i) they are better predictors of realized betas, and (ii) they exhibit smaller and less systematic prediction errors.