Abstract
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.
| Original language | English |
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| Pages (from-to) | 1377-1406 |
| Journal | Journal of Finance |
| Volume | 64 |
| Issue number | 3 |
| Publication status | Published - 2009 |