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Correlation Variability as Driver of the Volatility Risk Premium

| | Posted in: Equity Options, Volatility Effects

Correlations among asset returns vary over time, introducing risk to the benefits of diversification. Intervals of extraordinarily high correlation amplify marketwide volatility and are disruptive to asset allocation policies. Does the risk of such correlation shocks explain the volatility risk premium associated with marketwide (equity index) options? In the July 2008 version of their paper entitled “The Price of Correlation Risk: Evidence from Equity Options”, Joost Driessen, Pascal Maenhout and Grigory Vilkov examine how correlation shocks affect the returns of options for a broad stock index and of options for its individual component stocks. Using daily returns for the S&P 100 index, its components and associated options over the period 1996-2003, they conclude that:

  • Over the entire sample period, there a large equity index volatility risk premium (average annualized implied volatility of 24.7% versus realized volatility of 20.8%).
  • However, options on individual stocks, unlike index options, do not imply a significant volatility risk premium. If anything, there is weak evidence that realized volatility tends to be higher than option-implied volatility for individual stocks.
  • A strategy that sells index straddles and buys individual straddles and stocks generates a large risk-adjusted excess return of more than 10% per month, before trading frictions. This strategy resembles dispersion trading, which sells index options and buys individual options, but also takes positions in equity to hedge stock market risk. Because of high bid-ask spreads for individual options, realistic trading frictions largely eliminate the strategy’s market outperformance.
  • An interpretation of these results is that index options are expensive, unlike individual options, because they provide a valuable hedge against correlation shocks. In other words, index options insure against the risk of a loss of diversification benefits.
  • Market makers active in both index and individual options tend to earn the correlation risk premium, since option traders are generally net long index options and net short individual options.

In summary, evidence suggests that equity index options carry a price premium because of their value in hedging against shocks to return correlations among individual stocks. Options for individual stocks do not carry this premium.

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