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J. Driessen, P. Maenhout, and G. Vilkov: The Price of Correlation Risk: Evidence from Equity Options

May 20, 2009

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.

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