The Price of Correlation Risk: Evidence from Equity Options

The authors study whether exposure to market-wide correlation shocks affects expected option returns, using data on S&P100 index options, options on all components, and stock returns. The authors present 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 these findings of a high price of correlation risk.