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Option-Implied Dependence and Correlation Risk Premium

Published online by Cambridge University Press:  18 August 2023

Oleg Bondarenko*
Affiliation:
University of Illinois at Chicago Department of Finance
Carole Bernard
Affiliation:
Grenoble Ecole de Management Department of Accounting, Law and Finance, and Vrije Universiteit Brussel (VUB) Department of Economics and Political Sciences [email protected]
*
[email protected] (corresponding author)
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Abstract

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We propose a novel model-free approach to obtain the joint risk-neutral distribution among several assets that is consistent with options on these assets and their weighted index. We implement this approach for the nine industry sectors comprising the S&P 500 index and find that their option-implied dependence is highly asymmetric and time-varying. We then study two conditional correlations: when the market moves down or up. The risk premium is strongly negative for the down correlation but positive for the up correlation. Intuitively, investors dislike the loss of diversification when markets fall, but they actually prefer high correlation when markets rally.

Type
Research Article
Creative Commons
Creative Common License - CCCreative Common License - BY
This is an Open Access article, distributed under the terms of the Creative Commons Attribution licence (http://creativecommons.org/licenses/by/4.0), which permits unrestricted re-use, distribution and reproduction, provided the original article is properly cited.
Copyright
© The Author(s), 2023. Published by Cambridge University Press on behalf of the Michael G. Foster School of Business, University of Washington

Footnotes

We thank Jennifer Conrad (the editor) and Lorenzo Schoenleber (the referee) for many constructive suggestions that helped to improve the article. For valuable comments, we also thank Torben G. Andersen (discussant), Nicole Branger, Adrian Buss (discussant), Ian Dew-Becker, Hamed Ghanbari, Jens Jackwerth, Philippe Mueller (discussant), Paul Schneider (discussant), Fabio Trojani, Steven Vanduffel, Grigoriy Vilkov, Alex Weissensteiner, and seminar participants at the 2018 CDI Conference in Montreal, 2018 Conference in Honor of Bruno Dupire, 2019 Conference on Risk Management and Financial Innovation, 2019 ITAM Finance Conference, 2019 EFMA Meeting, 2019 Risk Day organized by ETH Zurich, 2018 CUNEF Madrid workshop on “New Frontiers in Financial Markets,” 2021 Vienna workshop on “Econometrics of Option Market,” 2020 WFA meeting, the Collegio Carlo Alberto, Northwestern University, NYU, the University of Lugano, and the University of Illinois at Chicago. An earlier version of this article was titled “Option-Implied Dependence” (with Steven Vanduffel). We also gratefully acknowledge funding from the Canadian Derivatives Institute (formerly IFSID), the FWO research grant FWO G015320N at the Vrije Universiteit Brussel and the Global Risk Institute (GRI).

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