Implied Correlation Index: A New Measure of Diversification

Abstract

Most approaches in forecasting future correlations depend upon the use of historical information as their basic information set. Recently, there have been some attempts to use the notion of implied correlation as a more accurate measure of future correlation. This study proposes an innovative methodology for backing-out implied correlation measures from index options. This index reflects the market view of the future level of the market portfolio diversification. The methodology is applied to the Dow Jones Industrial Average index and the statistical properties and the dynamics of the proposed implied correlation measure are examined. The evidence of this study indicates that the implied correlation index fluctuates substantially over time and displays strong dynamic dependence. Moreover, there is a systematic tendency for the implied correlation index to increase when the market index returns decrease and/or the market volatility increases indicating limited diversification when it is needed most. Finally, the forecast performance of the implied correlation index is assessed. Although the implied correlation index is a biased forecast of realized correlation, it has a high explanatory power and it is orthogonal to the information set compared to a historical forecast.