- The price of correlation risk: evidence from equity options
- The Journal of Finance
- Volume | Issue number
- 64 | 3
- Pages (from-to)
- Document type
- Faculty of Economics and Business (FEB)
- Amsterdam Business School Research Institute (ABS-RI)
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.
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