The Price of Correlation Risk: Evidence from Equity Options





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    • Driessen is at the University of Amsterdam. Maenhout and Vilkov are at INSEAD. We would like to thank Yacine Aït-Sahalia, David Bates, Jonathan Berk, Oleg Bondarenko, Michael Brandt, Menachem Brenner, John Campbell, Mike Chernov, Greg Duffee, Darrell Duffie, Rob Engle, Jan Ericsson, Gerard Gennotte, Jens Jackwerth, Chris Jones, Frank de Jong, Hayne Leland, Toby Moskowitz, Anthony Neuberger, Josh Rosenberg, Mark Rubinstein, Pedro Santa-Clara, Ken Singleton, Otto van Hemert, Robert Whitelaw, Zhipeng Zhang, and especially Bernard Dumas for comments and stimulating discussions. We are particularly grateful for the detailed and constructive comments of an anonymous referee and the Editor. We received helpful comments from seminar participants at Berkeley Haas School of Business, BI Oslo, Cornell Johnson School, HEC Lausanne, INSEAD, LBS-LSE-Oxford Asset Pricing Workshop, MIT Sloan, NY Fed, NYU Stern, Stanford GSB, Tilburg, University of Amsterdam, University of Bonn, University of Frankfurt, University of Rotterdam, Warwick Business School, Yale SOM, CEPR Summer Symposium Gerzensee, EFA 2005, Duke-UNC Asset Pricing Conference, and WFA 2006. We gratefully acknowledge the financial support of INSEAD R&D.


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.