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Ex-Ante Risk Factors and Required Structures of the Implied Correlation Matrix

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  • Schadner, Wolfgang

Abstract

This paper develops a method to improve estimation accuracy of the equity implied correlation matrix. The advantages of implied versus historical correlations are (i) that they actually reflect investor expectations and (ii) they are able to adopt for sudden changes in the market. While the complete solution to the matrix remains impossible, we address the puzzle from a factor pricing perspective and argue that certain structures are obligatory. Given so, the matrix can be refined into clusters of similar firm characteristics where coefficients are assessable. This allows to enhance the estimation precision while keeping the benefits from being fully forward-looking.

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  • Schadner, Wolfgang, 2021. "Ex-Ante Risk Factors and Required Structures of the Implied Correlation Matrix," Finance Research Letters, Elsevier, vol. 41(C).
    • Handle: RePEc:eee:finlet:v:41:y:2021:i:c:s154461232031669x
    DOI: 10.1016/j.frl.2020.101855
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    References listed on IDEAS

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    Cited by:

    1. Wolfgang Schadner, 2021. "Feasible Implied Correlation Matrices from Factor Structures," Papers 2107.00427, arXiv.org.
    2. Wolfgang Schadner & Joshua Traut, 2022. "Estimating Forward-Looking Stock Correlations from Risk Factors," Mathematics, MDPI, vol. 10(10), pages 1-19, May.

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    More about this item

    Keywords

    Implied Correlation; Equity; Expected Risk; Risk Factors; Option Implied Volatility;
    All these keywords.

    JEL classification:

    • G12 - Financial Economics - - General Financial Markets - - - Asset Pricing; Trading Volume; Bond Interest Rates
    • C58 - Mathematical and Quantitative Methods - - Econometric Modeling - - - Financial Econometrics

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