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The Price of Correlation Risk: Evidence from Equity Options

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  • JOOST DRIESSEN
  • PASCAL J. MAENHOUT
  • GRIGORY VILKOV

Abstract

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.

Suggested Citation

  • Joost Driessen & Pascal J. Maenhout & Grigory Vilkov, 2009. "The Price of Correlation Risk: Evidence from Equity Options," Journal of Finance, American Finance Association, vol. 64(3), pages 1377-1406, June.
  • Handle: RePEc:bla:jfinan:v:64:y:2009:i:3:p:1377-1406
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