Conditional dependence in post-crisis markets: dispersion and correlation skew trades

Strengthening of asset return dependence during the 2007–2008 credit crisis highlighted its dynamic and conditional nature. Option prices reflect the market assessment of how dependence between assets varies with price movements and time horizons, yielding the implied correlation surface. Return dependence increases in falling markets and makes correlation a priced risk factor, causing a spread between implied and actual correlation. Order flow pressure from hedging structured products also contributes to the spread. Prior to the crisis, the gap between implied and actual correlation motivated selling dependence between equities—dispersion trading. However, spiking dependence among stock returns during the crisis decimated correlation sellers. Selling at-the-money conditional correlation between NASDAQ-100 components regains an attractive risk-return profile during periods of strong bull market. This may be due to an increasing correlation risk premium caused by greater investor belief heterogeneity. The implied correlation surface enables the construction of strategies with exposures to dependence conditional on various market dynamics. In particular, a long correlation skew trade delivers attractive returns, while hedging the effects of volatility and mitigating exposure to the level of correlation. This suggests segmentation of the options market along the moneyness dimension. As a risk factor, a correlation skew trade is nearly orthogonal to the five Fama–French risk factors, as well as the momentum factor.