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Measuring Equity Risk with Option-implied Correlations

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  • Adrian Buss
  • Grigory Vilkov

Abstract

We use forward-looking information from option prices to estimate option-implied correlations and to construct an option-implied predictor of factor betas. With our implied market betas, we find a monotonically increasing risk-return relation, not detectable with standard rolling-window betas, with the slope close to the market excess return. Our implied betas confirm a risk-return relation consistent with linear factor models because, when compared to other beta approaches: (i) they are better predictors of realized betas, and (ii) they exhibit smaller and less systematic prediction errors. The predictive power of our betas is not related to known relations between option-implied characteristics and returns. The Author 2012. Published by Oxford University Press on behalf of The Society for Financial Studies. All rights reserved. For Permissions, please e-mail: journals.permissions@oup.com., Oxford University Press.

Suggested Citation

  • Adrian Buss & Grigory Vilkov, 2012. "Measuring Equity Risk with Option-implied Correlations," Review of Financial Studies, Society for Financial Studies, vol. 25(10), pages 3113-3140.
  • Handle: RePEc:oup:rfinst:v:25:y:2012:i:10:p:3113-3140
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    File URL: http://hdl.handle.net/10.1093/rfs/hhs087
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    Cited by:

    1. Schneider, Paul & Wagner, Christian & Zechner, Josef, 2016. "Low risk anomalies?," CFS Working Paper Series 550, Center for Financial Studies (CFS).
    2. Alexander Kempf & Olaf Korn & Sven Saßning, 2015. "Portfolio Optimization Using Forward-Looking Information," Review of Finance, European Finance Association, vol. 19(1), pages 467-490.
    3. Della Corte, Pasquale & Ramadorai, Tarun & Sarno, Lucio, 2016. "Volatility risk premia and exchange rate predictability," Journal of Financial Economics, Elsevier, vol. 120(1), pages 21-40.
    4. Amir Akbari & Francesca Carrieri & Aytek Malkhozov, 2017. "Reversals in Global Market Integration and Funding Liquidity," International Finance Discussion Papers 1202, Board of Governors of the Federal Reserve System (U.S.).
    5. Sylvia Sarantopoulou-Chiourea & George Skiadopoulos, 2015. "A New Predictor of Real Economic Activity: The S&P 500 Option Implied Risk Aversion," Working Papers 741, Queen Mary University of London, School of Economics and Finance.
    6. Baule, Rainer & Korn, Olaf & Saßning, Sven, 2013. "Which beta is best? On the information content of option-implied betas," CFR Working Papers 13-11, University of Cologne, Centre for Financial Research (CFR).
    7. Peter Christoffersen & Mathieu Fournier & Kris Jacobs, 2013. "The Factor Structure in Equity Options," CREATES Research Papers 2013-47, Department of Economics and Business Economics, Aarhus University.
    8. Christoffersen, Peter & Jacobs, Kris & Chang, Bo Young, 2013. "Forecasting with Option-Implied Information," Handbook of Economic Forecasting, Elsevier.
    9. Hollstein, Fabian & Prokopczuk, Marcel & Wese Simen, Chardin, 2017. "The Term Structure of Systematic and Idiosyncratic Risk," Hannover Economic Papers (HEP) dp-618, Leibniz Universität Hannover, Wirtschaftswissenschaftliche Fakultät.
    10. Brinkmann, Felix & Kempf, Alexander & Korn, Olaf, 2014. "Forward-looking measures of higher-order dependencies with an application to portfolio selection," CFR Working Papers 13-08 [rev.], University of Cologne, Centre for Financial Research (CFR).
    11. Brinkmann, Felix & Korn, Olaf, 2014. "Risk-adjusted option-implied moments," CFR Working Papers 14-07, University of Cologne, Centre for Financial Research (CFR).
    12. Hollstein, Fabian & Prokopczuk, Marcel, 2016. "Estimating Beta," Journal of Financial and Quantitative Analysis, Cambridge University Press, vol. 51(04), pages 1437-1466, August.
    13. Martin, Ian & Wagner, Christian, 2016. "What is the Expected Return on a Stock?," CEPR Discussion Papers 11608, C.E.P.R. Discussion Papers.
    14. Feunou Bruno & Tafolong Ernest, 2015. "Fourier inversion formulas for multiple-asset option pricing," Studies in Nonlinear Dynamics & Econometrics, De Gruyter, vol. 19(5), pages 531-559, December.
    15. Peter Christoffersen & Xuhui (Nick) Pan, 2014. "Equity Portfolio Management Using Option Price Information," CREATES Research Papers 2015-05, Department of Economics and Business Economics, Aarhus University.
    16. Muzzioli, Silvia, 2015. "The optimal corridor for implied volatility: From periods of calm to turmoil," Journal of Economics and Business, Elsevier, vol. 81(C), pages 77-94.
    17. Markopoulou, Chryssa & Skintzi, Vasiliki & Refenes, Apostolos, 2016. "On the predictability of model-free implied correlation," International Journal of Forecasting, Elsevier, vol. 32(2), pages 527-547.
    18. Hollstein, Fabian & Prokopczuk, Marcel & Wese Simen, Chardin, 2017. "How to Estimate Beta?," Hannover Economic Papers (HEP) dp-617, Leibniz Universität Hannover, Wirtschaftswissenschaftliche Fakultät.
    19. Sara Cecchetti & Laura Sigalotti, 2013. "Forward-looking robust portfolio selection," Temi di discussione (Economic working papers) 913, Bank of Italy, Economic Research and International Relations Area.
    20. Kempf, Alexander & Korn, Olaf & Saßning, Sven, 2014. "Portfolio optimization using forward-looking information," CFR Working Papers 11-10 [rev.], University of Cologne, Centre for Financial Research (CFR).
    21. Brinkmann, Felix & Kempf, Alexander & Korn, Olaf, 2013. "Forward-looking measures of higher-order dependencies with an application to portfolio selection," CFR Working Papers 13-08, University of Cologne, Centre for Financial Research (CFR).
    22. Cosemans, Mathijs & Frehen, Rik & Schotman, Peter & Bauer, Rob, 2016. "Estimating security betas using prior information based on firm fundamentals," Other publications TiSEM f0f91c05-b59e-454c-a102-a, Tilburg University, School of Economics and Management.

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