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. Copyright (c) 2009 The American Finance Association.
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Volume (Year): 64 (2009) Issue (Month): 3 (06) Pages: 1377-1406 Download reference. The following formats are available: HTML
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