Option-Implied Correlations, Factor Models, and Market Risk

Abstract

Implied correlation and variance risk premium stand out in predicting market returns. However, while the predictive ability of implied correlation lasts for up to a year, the variance risk premium predicts market returns only for one quarter ahead. Contrary to the accepted view, implied correlation predicts the market return not through a diversification risk (average correlation) channel, but by predicting a concentration of market exposure, which defines the level of non-diversifiable market risk, or systematic diversification. Economy-wide implied correlation built exclusively from option prices of nine sector ETFs and the S&P500 efficiently predicts future market returns and systematic diversification risk in the form of market betas dispersion. Newly developed implied correlations for economic sectors provide industry-related information and are used to extract option-implied risk factors from sector-based covariances.