The price of correlation risk: Evidence from equity options

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 indi-vidual 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, provid-ing a limits-to-arbitrage interpretation of our finding of a high price of correlation risk. CORRELATIONS PLAY A CENTRAL ROLE in financial markets. There is considerable ev-idence that correlations between asset returns change over time1 and that stock return correlations increase when returns are low.2 A marketwide increase in correlations negatively affects investor welfare by lowering diversification ben-efits and by increasing market volatility, so that states of nature with unusually high correlations may be expensive. It is therefore natural to ask whether mar-ketwide correlation risk is priced in the sense that assets that pay off well when marketwide correlations are higher than expected (thereby providing a ∗Driessen is at the University of Amsterdam. Maenhout and Vilkov are at INSEAD. We woul