Option-Implied Correlations, Factor Models, and Market Risk

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... [ view full 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 channel, but by predicting a concentration of market exposure, which defines the level of nondiversificable market risk (in the form of market betas dispersion). Newly developed implied correlations for nine economic sectors provide industry related information and are used to extract option-implied risk factors from sector-based covariances.