Abnormal Sector Option Correlation Premiums and Predictable Changes in Implied Volatility

Abnormal Sector Option Correlation Premiums and
Predictable Changes in Implied Volatility∗
Apoorva Koticha
D’Amore-McKim School of Business
Northeastern University
a.koticha@northeastern.edu
Chen Li
Isenberg School of Management
University of Massuchusetts Amherst
chenli@umass.edu
Joseph M. Marks†
D’Amore-McKim School of Business
Northeastern University
j.marks@northeastern.edu
June 8, 2021
Abstract
We examine options listed on sector ETFs that constitute the S&P 500 and find evidence
of predictability in implied volatilities associated with abnormally high or low implied correla-
tions. We show that sector implied volatilities evolve to maintain stable relations between sector
correlation premiums and the correlation premium on the S&P 500. The predictable variation
in sector implied volatilities associated with changes in implied correlation forms the basis for
profitable trading signals that dominate strategies based directly on sector volatility premiums.
Keywords: index options; implied correlation; correlation premium; sectors; implied volatility
JEL classification: G13
∗
We are grateful to Nikunj Kapadia, Jim Campasano, and Fousseni Chabi-Yo for comments and feedback on this
work and Hengyi Zhou for research assistance. All errors remain our own.
†
Corresponding author.
Electronic copy available at: https://ssrn.com/abstract=3862777

1 Introduction
Index options offer a rich context in which to study the formation of investor expectations. As
is the case with individual stock options, a primary determinant of the price of an index option
is expected volatility over the life of the option. However, forecasting the volatility of an index is
more difficult than forecasting the volatility of a stock because index volatility depends not only
on the volatilities of the stocks held in the index, but also on the correlations between the stocks.
Therefore, relative to stock options, the burden on an investor to correctly price index options is
greater to the extent that they must accurately forecast both stock volatilities and correlations.
Previous empirical studies focused on stock and index implied volatilities generally support two
conclusions. First, index options exhibit a significantly positive volatility premium measured as the
current implied volatility less recent realized volatility, and this volatility premium is smaller and
often negligible for stock options.1 Second, on average stock implied volatilities are good predictors
of future realized volatility over the life of the option and often outperform alternative predictors of
future volatility.2 While there is evidence of misreaction in stock implied volatilities, such cases are
associated with relatively infrequent idiosyncratic events such as extreme stock returns (e.g. Goyal
and Saretto (2009)) that would exert only a small effect on a diversified index. Taken together, these
findings create the impression that the stock implied volatilities on which index implied volatility
depends are on average approximately rational forecasts.
We posit that abnormalities in the short-term pricing of an index option can be better detected
by studying the implied correlation than the implied volatility. A high index volatility premium
may be attributed to rationally-expected high stock implied volatilities. In this case, the correlation
premium, defined analogously to the volatility premium as current implied correlation less recent
realized correlation, would not necessarily be high because implied correlation is calculated using
stock implied volatilities as inputs and therefore controls for their levels. On the other hand,
an abnormally high correlation premium can signal either rationally-expected high correlations or
1
The volatility premium can be justified on the basis of priced volatility risk (e.g. Bakshi and Kapadia (2003a),
Bakshi and Kapadia (2003b), and Bakshi and Madan (2006)), and also market imperfections including order imbal-
ances and arbitrage risk (e.g. Bollen and Whaley (2004) and Gârleanu, Pedersen, and Poteshman (2009)).
2
Poon and Granger (2003) provide a comprehensive review of the volatility forecasting literature and compare
the performance of forecasts derived from volatility models calibrated to historical data to forecasts extracted from
options data.

some temporary deviation in the index implied volatility. We demonstrate that it is often the latter
and that a measure of abnormal correlation premium is more predictive of future changes in sector
implied volatility than is the volatility premium. Building on this finding, we also show that trading
signals concerning sector option implied volatilities based on the abnormal correlation premium are
profitable in absolute terms, and also more profitable than conventional strategies based on the
volatility premium.
To demonstrate these results, we focus on sector index options because they facilitate measure-
ment of expected implied correlation, and hence abnormal correlation premium, in a novel way. We
propose a simple model in which sector correlation premiums covary with an aggregate correlation
premium extracted from the S&P 500. One motivation for our approach is that in rational models
of index option pricing, time-varying asset return correlations produce a risk for which risk-averse
investors demand compensation, which is manifest as a negative correlation premium.3 Shocks
to investor risk aversion that affect the premium associated with bearing correlation risk can be
expected to affect correlation premiums on the S&P 500 and sector options concurrently, thereby
inducing comovement. A second rationale for our model is based on the existence of market fric-
tions and limited liquidity in the options market. Bollen and Whaley (2004) show that demand
shocks, namely those resulting from an increase to hedge the downside risk of institutional portfo-
lios, increase index option prices and makes them appear expensive as measured by the volatility
premium. To the extent that sector options can be used as substitutes to hedge portfolio risk, such
a demand shock would be likely to affect the pricing of both S&P 500 options and sector options
at the same time, thereby inducing comovement in the correlation premiums of the S&P 500 and
sectors. The essential point is that if sector correlation premiums do evolve in reference to the S&P
500 correlation premium, then deviations from this typical behavior constitute an abnormality.
Our first empirical finding is that, consistent with the above discussion, sector correlation pre-
miums do strongly covary with the S&P 500 correlation premium. It appears that sector implied
volatilities evolve to maintain stable, long-term relations between the sector correlation premiums
and the S&P 500 correlation premium, and deviations from these relations quickly revert to re-
3
All else constant, index options increase in value when correlations between assets increase, thereby providing
a hedge against deterioration of the diversification benefit due to higher correlation. Investors view this hedge as
valuable and are therefore willing to accept a negative correlation risk premium attached to index options.

store it. We estimate predictive time series models that demonstrate abnormal sector correlation
premiums better predict daily changes in sector implied volatilities than do the levels of the sector
volatility premiums or the levels of the sector correlation premiums. We next explore how abnor-
mal levels of the correlation premium are related to subsequent realized correlations. We find that
abnormally high (low) measures of the correlation premium are associated with more (less) positive
forecast error. In other words, an abnormally high correlation premium tends to signal that the
implied correlation is well above future correlation. Finally, we measure the economic significance of
our findings by documenting the returns to trading strategies predicated on our signal of abnormal
correlation premium. These strategies predict increases (decreases) in sector implied volatilities
when the abnormal correlation premium is low (high) and buy (sell) straddles on the sector ETF to
profit from this expectation. To insulate the returns on these strategies from changes in the level of
market volatility and thereby focus their bet on the relative valuations of the sector options, these
strategies also take opposing positions on straddles associated with the SPY (i.e. short a straddle
on the SPY when long a straddle on the sector ETF). We find these trading strategies to be highly
profitable, with their average daily profits exceeding similar strategies based directly on the level
of the sector correlation or volatility premiums. The results concerning the profitability of these
trading strategies reinforce the conclusion that our measure of abnormal correlation premium is
significant and dominates more conventional predictors for short-term changes in implied volatility.
The remainder of this paper is organized as follows. Section 2 discusses background literature
and important research concerning index correlation premiums and their relation to volatility pre-
miums and correlation risk. Section 3 presents our main empirical findings showing the value of
abnormal correlation premium in predicting sector implied volatilities. Section 4 documents the
profitability of trading strategies based on abnormal correlation premium. Section 5 summarizes
the contribution of this research and provides concluding remarks.
2 Background and Related Literature
The work we present in this paper contributes to a large and diverse literature focused on
index option implied correlation. Because an equity index represents a portfolio of stocks, at all
times the variance of the return on the index depends on the variances of the individual stock

returns and the correlations between them. By observing the implied volatility associated with
an index option and the implied volatilities of the stocks held in the index, which are themselves
optionable, one can infer a measure of implied correlation. However, in general it is not possible
to recover a complete heterogeneous correlation matrix and restrictive identifying assumptions
must be made to produce a tractable problem. Some studies have employed a simple approach
to identify implied correlations, such as Skintzi and Refenes (2005) and Driessen, Maenhout, and
Vilkov (2009), who assume constant pairwise correlation between all stocks in the index. Other
studies adopt substantially more complicated methods, for instance the block diagonal structure
of Buss, Schöenleber, and Vilkov (2017) that assumes a constant correlation between stocks in
the same sector (with this intra-sector correlation varying across nine sectors), and correlations
between stocks in different sectors that depend only on the identities of the two sectors. Generally,
the important empirical conclusions documented about implied correlation do not depend on the
identification strategy.
One important empirical result documented of index implied correlation is its ability to predict
aggregate equity returns. Bernales and Valenzuela (2016) and Buss, Schöenleber, and Vilkov (2017)
show that implied correlation extracted from the S&P 100 and S&P 500, respectively, can predict
market returns for up to a year, and Faria, Kosowski, and Wang (2018) extend this result to
European stock indexes. The ability to predict market returns suggests that implied correlation
may be related to a risk factor; when time-varying stock correlations increase, investors suffer due
to the lower benefit derived from diversification, and thus high implied correlation leads the high
market returns that compensate lower utility. Indeed, Driessen, Maenhout, and Vilkov (2009) and
Buraschi, Kosowski, and Trojani (2014) provide evidence that index options are priced to offer
a negative correlation risk premium because they act as a hedge against unanticipated increases
in stock correlations. Whether a separate correlation risk premium is priced in equilibrium or is
subsumed by the variance risk premium of Bakshi and Kapadia (2003a) is not clear and is an area
of active research. However, there is ample evidence to suggest that implied correlation is not
wholly redundant relative to measures of volatility.4

4
For example, Fink and Geppert (2017) calculate the implied correlation associated with the DAX and show that
it is incrementally useful for forecasting volatility. Cosemans (2017) studies the S&P 100 and finds that implied
correlation is incrementally useful in predicting the return on the index relative to using volatility measures alone.

Our work does not address the important question of the existence of a separate correlation
risk premium. Instead, we begin with the assumption that the prices of index option exhibit short-
term deviations from rational pricing due to limited liquidity, market frictions, and time-varying
demand shocks. It is widely believed that the notion of imperfect markets plays a significant
role in explaining curious features of observed option prices. In particular, Bollen and Whaley
(2004) present strong evidence that the tendency for index implied volatilities to run higher than
recent historical or future volatility is connected to the tendency for institutional investors to hedge
equity portfolios with index puts (generating excess demand and high prices), whereas no such
volatility premium exists for stock options because individual investors are net suppliers through
their tendency to sell covered calls (excess supply and reduced prices). In a related paper, Gârleanu,
Pedersen, and Poteshman (2009) build a theoretical model in which investor demand contributes to
option pricing and corroborate the model empirically by studying the positions of options dealers.
Our analysis is based on the idea that if such price deviations do occur for index options, then the
implied correlation offers a better signal of mispricing than do often-studied and more conventional
variables such as the volatility premium.
3 Main Results
In this section, we study the behavior of sector correlation premiums and examine the relation
between these correlation premiums and changes in sector implied volatility. Section 3.1 describes
the data we use throughout this study, including calculation of sector implied correlations and cor-
relation premiums. Section 3.2 presents time-series models that demonstrate that future changes
in section option implied volatilities tend to restore long-run, stable relations between sector corre-
lation premiums and the correlation premium on the S&P 500. Section 3.3 examines the relation
between realized future sector correlation and volatility and information contained in the sector
correlation and volatility and premiums.
3.1 Data
Throughout this study, we focus on nine major SPDR sector ETFs that track the S&P Select
Sector Indices comprising the S&P 500, along with the SPY ETF that tracks the S&P 500. The

exchange ticker symbols for the nine sector ETFs are: XLF (financials), XLI (industrials), XLK
(technology), XLP (consumer staples), XLU (utilities), XLV (health care), XLY (consumer discre-
tionary), XLB (materials), and XLE (energy). We use the Compustat Index Constituents file to
observe the stocks that belong to the S&P 500 along with each stock’s GICS code. We then assign
each stock to the appropriate sector on the basis of its GICS code following the methodology that
Standard & Poor’s employs to create the Select Sector Indices that the sector SPDR ETFs track.
From the CRSP daily stock file we obtain the market capitalizations of each stock necessary to
compute the weight of each stock within its sector. We measure the sector weights for a stock on a
particular day as the value weight obtained by dividing that stock’s market cap by the sum of the
market caps of stocks included in the same sector. In this way, we are able to build a daily dataset
that details the nine sectors.
Next, from the OptionMetrics IvyDB database we obtain data for options listed on each of the
sector ETFs and all individual stocks that constitute the sectors. We observe interpolated options
for the period December 29, 1998, through December 31, 2018.5 Except where noted otherwise, the
empirical results we present are based on using 30-day at-the-money call options. OptionMetrics
provides daily observations of implied volatility for each of the options and realized volatility for
the individual stocks and ETF shares.
We use information taken from options written on the sector ETFs and the underlying individual
stocks along with and the sector weights to calculate the implied correlation associated with each
sector option. Let K be one of the nine sectors and let stocks i and j be constituents of sector K
with weights wi and wj , respectively. At any point in time, the variance of sector K is given by:
XX
2
σKt = wit wjt ρijt σit σjt (1)
i∈K j∈K
where σit and σjt are the standard deviations of returns on stock i and j at time t, and ρijt
is the correlation between their returns. Using implied volatilities extracted from options on the
individual stocks and sector ETF in place of the standard deviations above, we calculate the implied
5
OptionMetrics is missing option price and implied volatility data for XLY for the period January 19, 2002,
through February 4, 2003.

correlation for sector K as follows:
2
σKt
ρKt = P P (2)
i∈K j∈K wit wjt σit σjt
The implied correlation ρKt is the constant pairwise correlation within a sector (i.e. ρijt = ρKt for
all i, j) that equates the observed implied volatility on the sector ETF with the implied volatility of a
portfolio holding the individual stocks (the right-hand side of equation (1)). The implied correlation
can be regarded as a weighted average of the underlying pairwise correlations in which weights are
based on the stock sector weights and implied volatilities. Referring to ρKt as the implied correlation
index, Skintzi and Refenes (2005) study its properties for the Dow Jones Industrial Average and
provide a thorough discussion of its interpretation. We calculate daily time series of ρKt for the
nine sector options and options on SPY.
In addition to forward-looking implied correlation, we also calculate a historical measure of real-
ized correlation as the base for computing a correlation premium. Realized correlation is calculated
using equation (1), but rather than using implied volatilities, we use the observed 30-day realized
volatilities on the stocks and sector ETFs reported by OptionMetrics, along with sector weights
measured at the beginning of the 30-day period. We then calculate the correlation premium on
day t, which we denote as ρ̃Kt , as implied correlation observed using information at the close of
day t less 30-day realized correlation through day t. Analogous to measurement of the correlation
premium, we measure implied volatility and compare it to recent realized volatility for each of
the sector options in order to calculate a volatility premium for the sector. Consistent with prior
research, we measure the volatility premium at time t as σ̃Kt = log(IVKt /HVKt ), where IVKt is the
implied volatility of the sector option at time t, and HVKt is 30-day realized historical volatility
through date t.6
Table 1 provides summary statistics concerning the volatility and correlation premiums for the
SPY and the sector ETFs. We calculate the mean volatility premiums and test their significance
using the Newey and West (1987) method with five lags. Consistent with prior research focused
on the pricing of index options, we observe significantly positive volatility premiums associated
6
The correlation premium is not measured as the log ratio both because implied correlation does not exhibit the
same degree of skewness as does implied volatility, and the occurrence of negative values for implied correlation make
taking the log problematic.

with the SPY and all of the sector ETFs. The mean volatility premium for the sectors ranges
from a low of 0.039 for utilities (XLU) to a high of 0.104 for technology (XLK). However, all of
the sector option volatility premiums are below the volatility premium of the SPY, which averages
0.138 over this period. This finding is fitting with sector options lying somewhere between index
and individual stock options; like index options, sector options carry a positive volatility premium,
but due to their more narrow sector definitions, the magnitude is smaller and similar to individual
stock options for which the volatility premium is close to zero. Much past research has explained
the persistent positive volatility premium attached to index options as a rational premium earned
by investors for bearing volatility risk. Other studies such Bollen and Whaley (2004) argue that
the positive volatility premium signals the overpricing of index options due to the demand to hedge
the downside risk of long equity portfolios.
Panel B of Table 1 provides information on implied correlations and correlation premiums.
Calculating the mean correlation premiums and testing their significance as above, we document
significantly positive correlation premiums for the SPY and five of the nine sectors. Three of the
sectors (consumer staples, health care, and materials) have an average correlation premium indis-
tinguishable from zero, while utilities exhibit a significantly negative correlation premium. Looking
across the nine sectors, the mean correlation premium ranges from a high of 0.045 (financials) to
a low of -0.064 (utilities), with an average taken across sectors of 0.005. The mean correlation
premium for SPY is 0.044, and with the exception of XLF the sector correlation premiums are
substantially lower, echoing the results of the average sector volatility premiums which are smaller
than the SPY volatility premium. Driessen, Maenhout, and Vilkov (2009) document a positive cor-
relation premium for options on the S&P 100 and provide evidence that it is compensation earned
by investors for bearing correlation risk, as time varying correlations can affect index volatility sep-
arately from level increases in stock volatilities (i.e. index volatility can increase even if individual
stock volatilities remain constant). Other studies deny the existence of a separate correlation risk
premium. Our work in this paper does not require adopting one interpretation over the other,
and we therefore remain agnostic concerning the existence of a separate correlation risk premium,
but it is worth noting that the popularity of correlation swaps in addition to volatility swaps in
the OTC market suggests that portfolio managers view correlation risk as a separate risk to be

hedged. Instead of focusing on the level of the correlation premium, we focus on its time variation
as the basis for signals about future changes in sector option implied volatility. While estimates of
the average correlation premium are mixed across the sectors, all sectors exhibit substantial time
variation and wide dispersion in the correlation premium during this sample period. Consumer dis-
cretionary (XLY) has the most stable correlation premium with a standard deviation of 0.140 and
a 10th (90th) percentile of -0.380 (0.175). Unsurprisingly, materials (XLB) and consumer staples
(XLP), two of the sectors with insignificant average correlation premiums, are among the sectors
that also exhibit the greatest variation in correlation premium.
The time variation in the correlation premium is evident in Figure 1, where we plot it along
with implied volatility for the SPY and the nine sectors. Two important patterns are apparent in
these plots. First, the correlation premium is not strongly related to the level of implied volatility.
The contemporaneous correlation between sector implied volatility and sector correlation premium
ranges from a high of 0.21 for XLK to a low of -0.001 for XLY. Second, the correlation premium
shows less persistence than implied volatility, with extreme values of the correlation premium
quickly reverting towards the mean. The first-order autocorrelation associated with the correlation
premium averages approximately 0.85 across the sectors, as compared to an average first-order
autocorrelation of implied volatility of 0.96. This second finding suggests that the correlation
premium may capture short-term deviations in option pricing that are distinct from rational changes
in implied volatility. Indeed, the frequency of negative values for implied correlation within all
sectors suggests that it is influenced by forces that may not be rational.
3.2 Implied Correlation Dynamics
In this section, we explore factors that contribute to daily changes in the implied correlation
and correlation premium for each sector. We demonstrate that there is a common, systematic
component to the correlation premium that can be extracted from options on SPY, and that
not only do sector correlation premiums covary with this common component, but sector implied
volatilities move to restore the relation in correlation premiums. We begin by estimating the
10

following two models:
ρ̃Kt = αK + βK ρ̃SP Y,t + uKt (3)
σ̃Kt = αK + βK σ̃SP Y,t + vKt (4)
where ρ̃Kt (σ̃Kt ) is the sector option correlation (volatility) premium, and ρ̃SP Y,t (σ̃SP Y,t ) is the
correlation (volatility) premium associated with options on SPY. The two models are estimated
using the approach of Newey and West (1987) allowing for five lags of non-zero autocorrelation. The
results from estimating these two models for each of the sectors are presented in Table 2. The table
conveys strong relations between the sector and aggregate correlation premiums evidenced by the
positive and highly significant estimates of βK from equation (3), and this simple model explains
a substantial fraction of the variation in correlation premiums for most sectors. For comparison
to these results and use in later models, we also estimate equation (4) focused on the volatility
premium.
A link between sector correlation premiums and an aggregate correlation premium is not sur-
prising. Engle and Figlewski (2015) document that a systematic component drives stock implied
volatilities. Marks and Simon (2017) study sector option implied volatilities and, analogous to the
results from estimating (3), show that they are tied to aggregate implied volatility through sector
volatility premiums. Moreover, the link between sector and aggregate correlation premiums could
be expected on the basis of a variety of differing views about the source of the correlation premium.
If investors rationally expect higher correlations in the future, such as during market downturns,
then this expectation would affect the sectors and the SPY together. If the correlation premium is
regarded as a rational risk premium to compensate for correlation risk, then shocks to investor risk
aversion would also affect the magnitude of this premium on both the SPY and the sector options
at the same time. Finally, if the correlation premium instead reflects option valuation (i.e. a high
correlation premium signals options are expensive) then supply and demand shocks to the options
market would be expected to affect the pricing of broad index and sector options together, as the
latter can be used as substitutes to hedge the downside risk of a diversified portfolio.
We postulate that equation (3) captures a long-run relation between the sector and aggregate
correlation premiums and that deviations from this relation tend to revert quickly in order to
11

restore it. Therefore, future changes in the correlation premium would be more strongly tied to
these deviations than to the absolute level of the correlation premium. In essence, our approach
is focused on relative valuation in that the SPY and sector options can exhibit persistently high
correlation premiums so long as the sectors maintain their long-run relations to the aggregate
correlation premium. The intuition of the model follows an error correction model that restores
relative valuations. To test this idea, we estimate the following model of daily changes in the sector
implied correlation:
∆ρKt = αK + β1K ∆ρKt−1 + β2K ρ̃Kt−1 + β3K uKt−1 + εKt (5)
where ∆ρKt is the change in sector implied correlation from the close of day t − 1 to the close of day
t, ρ̃Kt−1 is the sector correlation premium on the close of day t − 1, and uKt−1 is the residual from
estimating equation (3). We refer to the uKt as measures of the abnormal correlation premium
as they capture the deviations of the sector correlation premium from its long-run relation to the
aggregate correlation premium. This measure of abnormal correlation premium plays a key role in
the remaining empirical work that we present. It is a well-documented result that daily changes
in index implied volatilities tend to reverse, so we include a lagged change in implied correlation
as a control.7 The remaining two terms allow us to test which variable exerts a stronger effect
on changes in implied correlation, the level of the correlation premium measured by ρ̃Kt−1 , or
deviations from the long-run relation between sector and aggregate correlation premiums captured
by uKt−1 .
Table 3 presents the results from estimating equation (5). We first estimate a reduced version
of this equation for each sector by omitting the term involving uKt−1 , the abnormal correlation
premium. In this restricted version of the model, the estimates of β2 for all sectors are negative
and highly significant, conveying that daily changes in sector implied correlations are related to the
levels of the correlation premiums: When the correlation premium is high (low) in absolute terms
on a given day, the implied correlation tends to decrease (increase) the following day. However, this
relation between the level of the correlation premium and subsequent changes in implied correlation
7
The empirical results associated with estimating equation (5) are qualitatively the same when replacing ∆ρKt−1
by ∆IVKt−1 , the lagged change in sector implied volatility.
12

appears to be a noisy proxy for a stronger relation involving relative valuation of the sector and
SPY options. When we estimate the full version of the model, we find that with the exception of
utilities (the only sector to exhibit a significantly negative average correlation premium) estimates
of β2 become insignificant for all sectors, the estimates of β3 are significantly negative, and the
adjusted R2 associated with the models increases slightly. The results demonstrate that it is not
a high sector correlation premium per-se that is associated with subsequent decreases in implied
correlation, but rather when the sector correlation premium is high relative to its typical relation
to the SPY correlation premium.
We next examine if the dominance of the abnormal correlation premium in explaining changes
in implied correlation also extends to explaining changes in implied volatility. To do so, we estimate
the following similar model:
∆IVKt = α + β1K ∆IVKt−1 + β2K σ̃Kt−1 + β3K uKt−1 + εKt (6)
where ∆IVKt is the change in sector implied volatility from the close of day t−1 to the close of day t,
and σ̃Kt−1 is the level of the sector volatility premium. The results from estimating (6) are provided
in Table 4 and reinforce the conclusion regarding the importance of relative valuation. Again we find
that the level of the volatility premium does strongly predict changes in implied volatility when used
alone, but that this power disappears in the presence of the abnormal correlation premium. The
results in Tables 3 and 4 are intuitive if one regards the abnormal correlation premium as capturing
temporary shocks to option prices. Investors may rationally expect future stock volatilities to be
high, which makes the level of the volatility premium an ambiguous measure of valuation. Similarly,
investors may also expect future correlations to be high, which would manifest as a high correlation
premium and likewise justify high option prices through a high implied volatility. However, if sector
correlation premiums tend to maintain stable relations with the SPY correlation premium, then an
abnormally high sector correlation premium is a better signal that the sector option is expensive,
and that both its implied volatility and implied correlation can be expected to fall to restore the
typical relative valuation.
13

3.3 Implied Correlation and Implied Volatility Forecast Error
We now turn our analysis to comparing implied correlation with future realized correlation
and volatility during the life of the option contract. We note at the outset that we do not expect
implied correlation to be an unbiased estimate of future realized correlation. In models of index
option valuation allowing for stochastic correlations, implied correlation is an unbiased estimate
of future correlation only when the risk-neutral and physical measures coincide. Empirically, the
summary statistics presented in Table 1 show that for many of the sectors there is a positive bias
associated with implied correlation relative to recent historically realized correlation.
We measure forecast error in a manner consistent with our earlier results. In particular, the
correlation forecast error for sector K at time t, denoted as ρεKt , is calculated as implied correlation
at time t less realized average correlation during the interval [t + 1 day, t + 30 days]. Realized
average correlation is the constant pairwise correlation that equates observed volatility on the
sector ETF during this interval with the volatility of the underlying portfolio, where sector weights
ε and measure
are measured at the end of day t. Similarly, we denote volatility forecast error as σKt
it as a percentage of realized volatility, computed as the log of the ratio of implied volatility at time
t to realized volatility during [t + 1, t + 30].
To examine potential relations between the implied correlation and correlation forecast error,
we estimate the following two models:
ρεKt = α + β1 uKt + εKt (7)
ρεKt = α + β1 uKt + β2 ρ̃Kt + β3 σ̃Kt + εKt (8)
A significantly positive value for β1 in equation (7) would mean that not only does a positive
abnormal correlation premium indicate the sector implied correlation is high relative to aggregate
implied correlation, but also that it is high relative to the correlations that are ultimately realized
within the sector. This suggests that the sector implied correlation may be too high by any rational
measure due to temporary mispricing. Based on our earlier results illustrating the importance
of relative valuations, we then estimate (8) to determine if the abnormal correlation premium
dominates as a signal that implied correlation may be too high.
14

Table 5 provides estimates of these two models. In Panel A, we find that β1 is positive, ranging
from 0.388 (industrials) to 0.628 (financials), and is very highly significant for all of the nine sectors.
Thus, considering that the average correlation forecast error captured by α tends to be positive
across the sectors, a positive abnormal correlation premium is indeed associated with an implied
correlation that is especially high relative to future correlation.8 This finding is consistent with the
notion that at times investors may be overpricing (underpricing) the sector options by incorporating
forecasts of future correlations that are too high (low), and that the abnormal correlation provides
a signal of these mispricings. To explore if the abnormal correlation premium offers a better signal
than simpler signals based on the levels of the correlation premium or volatility premium, we
estimate (8) and present the results in Panel B. These estimates support abnormal correlation
premium as the dominant signal of correlation forecast error. The estimates of β1 continue to be
positive and very highly significant for all sectors. In contrast, the coefficients associated with the
levels of both the correlation and volatility premiums are mixed. Estimates of β2 are insignificant
at the 5% level for six of the nine sectors, significantly positive for one sector (technology), and
significantly negative for two sectors (consumer staples and materials). Results for β3 are similarly
mixed, with six sectors exhibiting insignificant estimates and three sectors (financials, technology,
and energy) having significantly negative estimates. Furthermore, the magnitude of β1 also tends to
be substantially larger than β2 and β3 while the scales of the three variables are similar, reinforcing
the conclusion that abnormal correlation premium offers a stronger signal of forecast error. Finally,
the R2 from estimating the model changes very little when correlation and volatility premiums are
included, and the overall impression is that the levels of the correlation and volatility premiums
add little to the explanatory power of the abnormal correlation premium.
To motivate the trading strategies we study in Section 4, we also estimate the relation between
abnormal correlation premium and volatility forecast error using the following model:
ε
σKt = α + β1 uKt + β2 ρ̃Kt + β3 σ̃Kt + εKt (9)
We would expect that when the abnormal correlation premium is positive, on average the implied
8
Even for XLF (financials) and XLU (utilities) which exhibit negative average correlation forecast error, there is
a significantly positive relation between abnormal correlation premium and correlation forecast error.
15

volatility is too high so that estimates of β1 are expected to be significantly positive. While this
expectation is intuitive, it is worth noting that it does not follow automatically from the results
obtained from estimating equation (8) because sector volatility forecast error is also affected by
errors in the prediction of individual stock volatilities that may offset correlation forecast error.
The estimates of (9), presented in Panel C of Table 5, are consistent with the results in Table
4 that point to abnormal correlation premium as a better signal of irregularities in sector implied
volatilities. The estimates of β1 are again positive and significant at the 5% for all sectors except
utilities. To gain an idea of the magnitude of this relation, the median estimate of β1 is 0.471
(health care), which implies that a one standard deviation increase to abnormal correlation premium
equal to 0.126 is associated with an increase to volatility forecast error of 0.059. This incremental
forecast error is quite large compared to the mean volatility premium of 0.093 on XLV. Also
consistent with our earlier results are mixed estimates of β2 and β3 . The estimates of β2 are
insignificant for all sectors except consumer staples and materials, which both have significantly
negative values that are smaller in magnitude than β1 . Examining β3 , four of the sectors have
significantly positive estimates, three have insignificantly positive estimates, and the remaining
two sectors have insignificantly negative estimates. The tendency towards positive estimates of β3
implies that a high volatility premium can also be useful as a signal of high sector implied volatility.
This finding fits with the idea that sector implied volatilities can be high relative to realized volatility
due to overestimating the correlations between assets, and also because individual stock volatilities
may be overestimated. The fact that four of the sectors exhibit significantly positive estimates of
both β1 and β3 suggests both channels do in reality lead to volatility forecast error.
4 Trading Strategies
In this section, we examine the returns to various trading strategies motivated by the results
presented in Section 3. In particular, we compare the profitability of trading strategies that rely
on the abnormal correlation premium as a signal to alternative strategies that use level variables
and focus on volatility as a signal. This analysis provides a measure of the economic significance
of our findings.
16

4.1 Definition of Trading Strategies and Computing Profits
We generate daily buy and sell trade signals for each sector based on different indicators for the
expected change in sector implied volatility. For all the strategies that we consider, if the generated
signal is a buy signal, we purchase both 30-day at-the-money call and put options on the sector at
the close of the day to form a long straddle position. Because we adopt a one-day holding period
for these strategies, the use of at-the-money straddles eliminates the need to delta-hedge the trade.
Similarly, a sell signal is used to motivate a short at-the-money straddle in 30-day sector options
which is held for one day. While these strategies are delta-neutral, they are not vega-neutral so
that changes to the overall level of volatility may contribute to the resulting profit or loss. To
insulate the strategy from changes in the overall level of volatility, we take an offsetting position in
a straddle using SPY options. In particular, for any trade, we first determine a dollar vega amount
in advance as described below. Following a buy (sell) signal for that trade, we hold long (short)
at-the-money straddles in sector options in a quantity that achieves the assumed long (short) dollar
vega exposure. We then take the opposite dollar vega position in SPY straddles, i.e. short (long)
at-the-money straddles in SPY options in a quantity that achieves short (long) the same amount of
dollar vega. This forms a composite position holding four options (two sector options and two SPY
options) that is both delta-neutral and vega-neutral. Using offsetting straddles ties the strategy
closely to changes in the sector implied volatility relative to changes in the implied volatility of
the S&P 500 so that profits and losses result from the predictable changes in relative valuation on
which we focus in Section 3. There are undoubtedly alternative strategies appropriate for study in
this section, but we believe these offsetting straddles are parsimonious and an effective means of
exploiting the predictability documented above.
We close out each position at the end of the next trade day and then generate a new signal for
a new trade also to be held for one day. Based on this strategy, the daily volatility profit or loss
associated with a buy signal is computed as the sum of the changes in the implied volatilities of the
at-the-money sector call and at-the-money sector put less the sum of the changes in the implied
volatilities of the at-the-money SPY call and the at-the-money SPY put. Likewise, the volatility
profit associated with a sell signal is the sum of the changes in the implied volatilities of the SPY
options less the sum of the changes in implied volatilities of the sector options. The overall dollar
17

profit or loss is computed as the daily volatility profit times the dollar vega of the trading strategy.
For convenience and without loss of generality, we assume each day the strategy is invested in a
constant dollar vega of $10,000 per option so that each day the strategy is long $20,000 vega of
either sector or SPY options, and short $20,000 vega in the offsetting options.
For each sector, we examine four pieces of information to generate signals, each of which is used
to define a particular trading strategy. The strategies are implemented independently within each
sector and in the following section we present the profits and losses accruing to each strategy for
each sector. All strategies are constructed to ensure that there is no look-ahead bias affecting the
trade signals.
• LvlVolPrem Signal: This strategy is focused on the level of the sector volatility premium.
When the level of volatility premium is lower (higher) than its historical average calculated
using all sample data available at that point in time, then the resulting signal is a buy (sell).
• LvlCorrPrem Signal: This strategy is focused on the level of the sector correlation premium.
When the level of the correlation premium is lower (higher) than its historical average, again
computed using all data available at the time, the resulting signal is a buy (sell).
• AbVolPrem Signal: This strategy is focused on the sign of the abnormal sector volatility
premium, defined as the residual vKt from equation (4). The regression is estimated in an
adaptive manner using only data available up to the day the signal is generated. When the
abnormal volatility premium is negative (positive), the resulting signal is a buy (sell).
• AbCorrPrem Signal: This strategy is focused on the signal of the abnormal sector correlation
premium, defined as the residual uKt from equation (3). The regression is estimated in an
adaptive manner using only data available up to the day the signal is generated. When the
abnormal correlation premium is negative (positive), then the resulting signal is a buy (sell)
signal.
4.2 Profitability of Trading Strategies
We first test if any of the above signals are informative in the sense that they lead to profitable
trading strategies. Table 6 presents the average daily profits associated with each of the four trading
18

strategies for the nine sectors along with Newey and West (1987) t-statistics using five lags below
in parentheses. The weakest of the four signals is the level of the volatility premium, which is still
informative and is able to generate significantly positive profits for all sectors with the exception
of XLE. The daily profits associated with using this signal range from approximately $386 for XLI
to $850 for XLP. The profit associated with using the volatility premium as a signal increases and
becomes more statistically significant when the signal is based on the abnormal volatility premium
rather than simply the level. The third column demonstrates this result as the profit associated
with the AbVolPrem strategy is generally twice as large or more relative to the LvlVolPrem strategy
and is significant at the 1% level for all nine sectors. The LvLCorrPrem strategy also produces
a positive profit that is significant at the 1% level for all nine sectors, and the magnitude of the
profit based on the level of the correlation premium exceeds the profit of the LvLVolPrem strategy
by a substantial margin for all sectors. The fact that the LvLCorrPrem dominates the LvlVolPrem
strategy is consistent with the results presented in Table 4 showing that changes in implied volatility
are better predicted by the correlation premium. The last column presents the profits accruing to
the strategy based on the abnormal correlation premium. The abnormal correlation premium is
the most informative signal, producing the largest and most significant profits for all of the nine
sectors. The daily profits for the AbCorrPrem range from a low of $1403 (XLU) to a high of $3704
(XLF).
To provide more detail about the profitability of the four strategies, we present plots of the
cumulative returns earned over the sample period. Figure 2 is focused on the two level strategies
and presents a plot for each sector showing the cumulative profit to the LvlCorrPrem strategy
(green), LvlVolPrem strategy (red), and the difference between these two curve in yellow. Figure
3 is similar but is focused on the AbCorrPrem strategy (green), AbVolPrem strategy (red), and
the difference between them (yellow). These plots reinforce the conclusions from Table 6 that all
of these strategies produce economically significant profits, and moreover that profitability is not
tied to specific time periods or market environments. In Section 4.3 we further demonstrate this
conclusion by examining the performance of these trading strategies within subperiods.
Two main points emerge from the results presented in Table 6 and Figures 2 and 3. First,
abnormal measures of sector volatility and correlation relative to the SPY appear to dominate
19

simpler signals based on levels. Second, the correlation premium appears to be a better signal than
the volatility premium. We test these two ideas formally in Table 7 by differencing the daily time
series of profits to compare the strategies and testing the resulting average daily differences using
Newey and West (1987) t-statistics with five lags. The first two columns of Table 7 compare signals
derived from abnormal measures relative to signals based on levels. The first column measures the
incremental profit associated with the abnormal volatility premium relative to using the level of the
volatility premium. The incremental profit is significantly larger when using the abnormal volatility
premium for eight of the nine sectors, with XLP being the only exception as above. The second
column conducts the analogous test for the correlation premium and we obtain the same result that
a signal based on the abnormal correlation premium is more profitable than a signal based on levels
for eight of the nine sectors. The remaining two columns compare the use of the correlation premium
to the volatility premium. The third column measures the incremental profit associated with using
the level of the correlation premium relative to the level of the volatility premium. Consistent with
the earlier results, we find that the correlation premium offers a better signal for eight out of the
nine sectors, producing a substantially larger and statistically significant incremental profit. The
last column examines the performance of the abnormal correlation premium as a signal relative to
the abnormal volatility premium, and here we find yet again that the abnormal correlation premium
continues to dominate the abnormal volatility premium for seven of the sectors, with the remaining
two sectors (XLB and XLU) exhibiting positive but statistically insignificant incremental profits.
In summary, the results presented in Table 7 provide rigorous confirmation that the abnormal
correlation premium constitutes the dominant trading signal.
We conclude our work in this section by examining how the trading strategies are correlated
across the nine sectors. While our earlier results show that the levels of the volatility and correla-
tion premiums associated with each sector are tied to the SPY, it is not clear if abnormal measures
for these variables occur at the same time across the sectors. To provide an answer, we measure
the overlap in signals as the time series correlation between daily buy signals (+1) and sell signals
(-1) for each combination of sectors and present the results in Figure 4. This figure conveys sev-
eral notable patterns. First, it is apparent that the average correlations in 4(b) are substantially
less than 4(a), and likewise correlations in 4(d) are less positive than those in 4(c), demonstrat-
20

ing that signals derived from implied correlations are less correlated across sectors than signals
based on volatility. Second, the signals based on abnormal measures of volatility and correlation
show markedly less overlap across sectors than do signals based on levels; correlations decrease
substantially when comparing 4(c) to 4(a) and 4(d) to 4(b). Finally, the correlations of trade
signals associated with abnormal correlation premium in 4(d) are not only low when compared to
the other strategies, but also tend to be quite low in absolute terms. In Figure 5, we measure the
correlations in the daily profits and losses rather than the correlations of the trade signals and the
three patterns described above are equally evident here. The overall conclusion is that a trading
strategy based on abnormal correlation premium and implemented simultaneously across the nine
sectors is particularly attractive. In addition to offering the largest average profit out of the four
strategies we study, the abnormal correlation premium strategy is also naturally best diversified
across the sectors.
4.3 Sub-Period Results
The profits accruing to the trading strategies, and in particular the large profit associated with
signals based on the abnormal correlation premium, do not appear concentrated in certain times
or specific market environments. Some evidence of this can be observed in Figure 3, where both
the green curve (the cumulative profit on the abnormal correlation premium strategy) and the
yellow curve (its incremental profit relative to the abnormal volatility strategy) consistently trend
upwards rather than plateauing for intervals. To further investigate the potential for differences
in performance over time we examine our earlier results within two subperiods bifurcated by The
Financial Crisis, with the first subperiod spanning 1998–2008 and the second subperiod covering
2009–2018. This choice for the definition of subperiods provides roughly equal sample sizes for
both, and allows us to isolate the dramatic events of 2000–2002 and 2007–2008 to a first “pre-
crisis” subperiod and the latter half of the sample to a less volatile “post-crisis” subperiod.
As a first step, to visually verify that the abnormal correlation premium is consistently prof-
itable throughout the sample period, we break the plots in Figure 3 into the two subperiods and
present the cumulative profit during the first subperiod in Figure 6 and the cumulative profit in
the second subperiod in Figure 7. These two figures echo the full sample results and again show
21

a consistent upward trend in the green curve for each sector, so that profitability does not appear
related to differing market environments such as aggregate market returns, the level of volatility, or
macroeconomic state. The incremental profit relative to using the volatility signal does not show as
consistent an upward trend, but neither does it exhibit an obvious relation to market environment.
To conduct a more rigorous test focused on all the trading strategies, we measure the average
daily dollar profit accruing to each strategy separately for the two subperiods. To do so, we
independently estimate the parameters that form the basis for generating the four trade signals
(i.e. the historical averages and regression coefficients used to define abnormal measures). Table 8
provides the estimates during the first subperiod and Table 9 provides identical measures for the
latter subperiod. The results observed for each subperiod are qualitatively identical to the results
obtained using the full sample in Table 6. In particular, examining panel (a) of both tables reveals
that the abnormal correlation premium strategy produces a positive and highly significant profit for
all nine of the sectors during both subperiods. This is not true of any of the other three strategies,
which all tend to perform well in the pre-crisis period but deteriorate substantially in the second
subperiod. This is especially true regarding the level of the volatility premium, which produces an
insignificant profit for all sectors in the post-crisis period and an average loss for 4 of the 9 sectors.
Comparing the strategies it can be seen that, with very rare exception, the abnormal correlation
premium offers the highest profit out of the four strategies in both subperiods for all nine of the
sectors.9 Therefore, not only is the abnormal correlation premium trading strategy consistently
profitable in absolute terms, but it consistently outperforms the other strategies as well.
5 Conclusions
We document that the correlation premiums of options on the SPY ETF and the sector ETFs
that constitute the S&P 500 evolve in reference to each other. In particular, there is a tendency for
implied volatilities associated with the sector options to move in order to maintain stable, long-run
relations between sector correlation premiums and the SPY correlation premium. This tendency
leads to predictable changes in sector implied volatilities, as abnormally high or low sector correla-
9
The only two exceptions are AbCorrPrem-LvlCorrPrem for XLB in the first subperiod, and AbCorrPrem-
AbVolPrem for XLU also in the first subperiod.
22

tion premiums relative to the SPY correlation premium can be expected to revert in order to restore
the more typical relation. We document this predictability and demonstrate that abnormal values
of the correlation premium are not just abnormal in reference to the SPY correlation premium, but
are also associated with greater correlation forecast error measured relative to subsequent realized
correlations. Finally, we show that this predictability is sufficiently reliable to offer large and sta-
tistically significant profits to delta-neutral and vega-neutral trading strategies that extract signals
from the abnormal correlation premium.
The empirical results we document evoke important questions: What forces sector implied cor-
relations to deviate so dramatically from reasonable reference points, whether that reference be
recent historical correlations, the correlation premium associated with the SPY, or future realized
correlations? Do sector implied correlations tend to overreact to short-term events, thereby pro-
ducing abnormally high or low correlation premiums? If so, then what events tend to have this
effect? We leave the study of these interesting questions to future work.
References
Bakshi, Gurdip, and Nikunj Kapadia, 2003a, Delta-hedged gains and the negative market volatility
risk premium, Review of Financial Studies 16, 527–566.
, 2003b, Volatility risk premiums embedded in individual equity options, Journal of Deriva-
tives 11, 45–54.
Bakshi, Gurdip, and Dilip Madan, 2006, A theory of volatility spreads, Management Science 52,
1945–1965.
Bernales, Alejandro, and Marcela Valenzuela, 2016, Implied correlation and market returns, SSRN
Working Paper 2739757.
Bollen, Nicolas P.B., and Robert E. Whaley, 2004, Does net buying pressure affect the shape of
implied volatility functions?, Journal of Finance 59, 711–753.
Buraschi, Andrea, Robert Kosowski, and Fabio Trojani, 2014, When there is no place to hide -
correlation risk and the cross-section of hedge fund returns, Review of Financial Studies 27,
581–616.
Buss, Adrian, Lorenzo Schöenleber, and Grigory Vilkov, 2017, Option-implied correlations, factor
models, and market risk, SSRN Working Paper 2906484.
23

Cosemans, Mathijs, 2017, The pricing of long and short run variance and correlation risk in stock
returns, SSRN Working Paper 1825934.
Driessen, Joost, Pascal J. Maenhout, and Grigory Vilkov, 2009, The price of correlation risk:
Evidence from equity options, Journal of Finance 64, 1377–1406.
Engle, R., and S. Figlewski, 2015, Modeling the dynamics of correlations among implied volatilities,
Review of Financial Studies 19, 991–1018.
Faria, Gonçalo, Robert Kosowski, and Tianyu Wang, 2018, The correlation risk premium: Inter-
national evidence, SSRN Working Paper 3276601.
Fink, Holger, and Sabrina Geppert, 2017, Implied correlation indices and volatility forecasting,
Applied Economics Letters 24, 584–588.
Goyal, Amit, and Alessio Saretto, 2009, Cross-section of option returns and volatility, Journal of
Financial Economics 94, 310–326.
Gârleanu, Nicolae, Lasse Heje Pedersen, and Allen M. Poteshman, 2009, Demand-based option
pricing, Review of Financial Studies 22, 4259–4299.
Marks, Joseph M., and David P. Simon, 2017, Sector option implied volatility dynamics and pre-
dictability, Journal of Derivatives 25, 22–42.
Newey, Whitney K., and Kenneth D. West, 1987, A simple, positive semi-definite, heteroskedasticity
and autocorrelation consistent covariance matrix, Econometrica 55, 817–858.
Poon, Ser-Huang, and Clive W.J. Granger, 2003, Forecasting volatility in financial markets: A
review, Journal of Economic Literature 41, 478–539.
Skintzi, Vasilki, and Apostolos-Paul N. Refenes, 2005, Implied correlation index: A new measure
of diversification, Journal of Futures Markets 25, 171–197.
24

Table 1: Summary Statistics
We use information on interpolated 30-day at-the-money call options on nine SPDR sector ETFs that comprise the S&P 500 over the sample period
December 29, 1998, through December 31, 2018. The nine sector ETFs are XLF (financials), XLI (industrials), XLK (technology), XLP (consumer
staples), XLU (utilities), XLV (health care), XLY (consumer discretionary), XLB (materials), and XLE (energy). For each sector, we calculate
daily observations of implied correlation as the constant pairwise correlation that equates the implied volatility of the sector option with the implied
volatility of a portfolio holding the individual stocks contained in the sector. Realized historical correlation is measured over the 30 days ending on
the day implied correlation is observed, and is calculated as the constant pairwise correlation that equates realized volatility on the sector ETF and
realized volatility on a portfolio holding the individual stocks, where portfolio (sector) weights are measured at the beginning of the 30-day period.
The correlation premium is computed as the implied correlation less realized historical correlation. Similarly, the volatility premium is measured as
log(IV /HV ), where IV is the implied volatility of the sector option and HV is the historical volatility of the sector ETF measured during the 30
days ending on the date implied volatility is observed. Implied correlations and implied volatilities are winsorized at 1% and 99%. Mean volatility
and correlation premiums are tested using the method of Newey and West (1987) and allowing for five lags. Statistical significance at the 10%, 5%,
and 1% levels is denoted by ∗ , ∗∗ , and ∗∗∗ , respectively.
SPY XLF XLI XLK XLP XLU XLV XLY XLB XLE
25
Panel A: Volatility
Mean implied volatility 0.177 0.241 0.193 0.231 0.142 0.163 0.167 0.196 0.219 0.239
Mean realized historical volatility 0.163 0.235 0.184 0.218 0.135 0.164 0.159 0.186 0.214 0.238
Volatility Premium
Mean 0.138∗∗∗ 0.090∗∗∗ 0.087∗∗∗ 0.104∗∗∗ 0.093∗∗∗ 0.039∗∗∗ 0.093∗∗∗ 0.103∗∗∗ 0.054∗∗∗ 0.042∗∗∗
Median 0.152 0.096 0.085 0.100 0.109 0.048 0.095 0.119 0.064 0.047
Standard deviation 0.240 0.250 0.239 0.249 0.268 0.254 0.256 0.239 0.235 0.220
10th percentile -0.481 -0.534 -0.493 -0.499 -0.597 -0.635 -0.623 -0.494 -0.626 -0.565
90th percentile 0.434 0.404 0.398 0.419 0.430 0.350 0.416 0.401 0.353 0.319
Panel B: Correlation

Mean implied correlation 0.384 0.618 0.453 0.417 0.367 0.524 0.365 0.361 0.569 0.666
Mean realized historical correlation 0.340 0.572 0.437 0.384 0.360 0.588 0.364 0.353 0.561 0.676
Correlation Premium
Mean 0.044∗∗∗ 0.045∗∗∗ 0.017∗∗∗ 0.033∗∗∗ 0.007 -0.064∗∗∗ 0.002 0.008∗∗ 0.008 -0.010∗∗
Median 0.048 0.043 0.017 0.025 0.015 -0.061 0.009 0.017 0.006 -0.005
Standard deviation 0.103 0.151 0.155 0.154 0.165 0.175 0.149 0.140 0.174 0.168
10th percentile -0.230 -0.326 -0.368 -0.321 -0.425 -0.561 -0.479 -0.380 -0.454 -0.478
90th percentile 0.172 0.237 0.222 0.213 0.212 0.154 0.183 0.175 0.233 0.199
Table 2: Linking Sector Correlation and Volatility Premiums to Aggregate Premiums
We estimate the below two regressions using daily observations:
ρ̃Kt = αK + βK ρ̃SP Y,t + uKt (Model 1)

σ̃Kt = αK + βK σ̃SP Y,t + vKt (Model 2)
where ρ̃Kt is the sector option correlation premium and ρ̃SP Y,t is the correlation premium associated with
options on SPY. Similarly, σ̃Kt and σ̃SP Y,t denote the volatility premiums associated with the sector options
and options on SPY, respectively. Variables are winsorized at 1% and 99% and regression standard errors
are adjusted using the Newey and West (1987) method assuming five lags. Significance at the 10%, 5%, and
1% levels are indicated by *, **, ***, respectively.
Model 1 Model 2
2
Sector αK βK R αK βK R2
XLF 0.016*** 0.659*** 0.195 -0.020*** 0.798*** 0.598
(3.54) (18.28) (3.63) (40.74)
XLI -0.020*** 0.823*** 0.296 -0.023*** 0.795*** 0.629

(4.69) (24.20) (4.72) (45.31)
XLK -0.007* 0.894*** 0.348 -0.006 0.790*** 0.590

(1.85) (30.28) (1.16) (44.70)
XLP -0.021*** 0.631*** 0.154 0.001 0.664*** 0.360

(4.18) (15.42) (0.16) (28.04)
XLU -0.071*** 0.152*** 0.007 -0.023*** 0.442*** 0.177

(12.63) (3.15) (2.63) (14.21)
XLV -0.029*** 0.707*** 0.234 -0.013** 0.764*** 0.510

(6.84) (21.93) (2.04) (37.26)
XLY -0.030*** 0.855*** 0.410 -0.008 0.772*** 0.607

(8.57) (28.49) (1.52) (42.44)
XLB -0.019*** 0.612*** 0.129 -0.032*** 0.618*** 0.395

(3.68) (14.15) (5.03) (27.18)
XLE -0.032*** 0.481*** 0.082 -0.034*** 0.546*** 0.348

(6.23) (10.35) (5.32) (21.57)
26

Table 3: Daily Changes in Sector Implied Correlations
We examine the relation between changes in sector implied correlations and both the level of the correlation
premium and the abnormal correlation premium by estimating:
∆ρKt = α + β1K ∆ρKt−1 + β2K ρ̃Kt−1 + β3K uKt−1 + εKt
where ∆ρKt is the change in the sector implied correlation from the close of day t−1 through the close of day
t, ρ̃Kt−1 is the level of correlation premium measured as implied correlation less recent realized correlation,
and uKt is the abnormal correlation premium measured as deviations of the sector correlation premium
from its long-run relation with the SPY correlation premium. The t-statistics provided in parentheses are
measured using the Newey and West (1987) method allowing for five lags and variables are winsorized at 1%
and 99%. Significance at the 10%, 5%, and 1% levels are indicated by *, **, ***, respectively.
α β1 β2 β3 R2 α β1 β2 β3 R2
XLF (Financials) XLV (Health Care)

0.004*** -0.319*** -0.096*** 0.160 0.000 -0.331*** -0.054*** 0.144
(4.58) (-18.09) (-11.09) (0.42) (-21.49) (-9.86)
0.000 -0.311*** 0.001 -0.123*** 0.167 0.000 -0.325*** 0.011 -0.085*** 0.152
(-0.08) (-17.51) (0.10) (-7.43) (0.24) (-21.14) (1.20) (-7.12)
XLI (Industrials) XLY (Consumer Discretionary)

0.001 -0.353*** -0.077*** 0.175 0.000 -0.354*** -0.045*** 0.154
(1.55) (-23.09) (-11.92) (0.54) (-20.52) (-7.66)
0.000 -0.343*** -0.016 -0.089*** 0.181 0.000 -0.345*** 0.011 -0.097*** 0.167
(0.30) (-22.28) (-1.52) (-6.52) (-0.11) (-20.27) (1.36) (-7.65)
XLK (Technology) XLB (Materials)

0.002*** -0.261*** -0.065*** 0.107 0.000 -0.332*** -0.081*** 0.163
(2.91) (-12.40) (-7.18) (0.29) (-19.29) (-10.70)
0.000 -0.248*** -0.005 -0.093*** 0.117 0.000 -0.329*** -0.001 -0.093*** 0.166
(0.38) (-11.90) (-0.57) (-6.45) (-0.36) (-19.17) (-0.05) (-5.06)
XLP (Consumer Staples) XLE (Energy)

0.001 -0.362*** -0.075*** 0.181 -0.001 -0.319*** -0.078*** 0.151
(0.57) (-25.27) (-10.75) (-0.57) (-18.85) (-11.16)
0.000 -0.356*** 0.011 -0.102*** 0.186 0.000 -0.316*** 0.011 -0.097*** 0.154
(-0.06) (-24.65) (0.73) (-6.22) (0.37) (-18.57) (0.55) (-4.46)
XLU (Utilities)
-0.006*** -0.355*** -0.102*** 0.191
(-4.57) (-20.38) (-11.13)
0.011** -0.354*** 0.164** -0.268*** 0.193
(2.50) (-20.37) (2.52) (-4.06)
27

Table 4: Daily Changes in Sector Implied Volatilities
We examine the relation between changes in sector implied volatilities and both the level of the volatility
premium and the abnormal correlation premium by estimating:
∆IVKt = α + β1K ∆IVKt−1 + β2K σ̃Kt−1 + β3K uKt−1 + εKt
where ∆ρKt is the change in the sector implied correlation from the close of day t−1 through the close of day
t, σ̃Kt−1 is the level of volatility premium measured as implied volatility less recent realized volatility, and
uKt is the abnormal correlation premium measured as deviations of the sector correlation premium from its
long-run relation with the SPY correlation premium. The t-statistics provided in parentheses are measured
using the Newey and West (1987) method allowing for five lags and variables are winsorized at 1% and 99%.
Significance at the 10%, 5%, and 1% levels are indicated by *, **, ***, respectively.
α β1 β2 β3 R2 α β1 β2 β3 R2
XLF (Financials) XLV (Health Care)

0.001 -0.257*** -0.018*** 0.074 0.003*** -0.300*** -0.031*** 0.108
(1.30) (-14.84) (-3.59) (2.50) (-18.38) (-6.86)
-0.001 -0.240*** 0.009 -0.107*** 0.094 0.000 -0.295*** -0.003 -0.094*** 0.120
(-0.76) (-13.78) (1.57) (-9.61) (0.31) (-18.23) (-0.62) (-7.82)
XLI (Industrials) XLY (Consumer Discretionary)

0.002** -0.291*** -0.027*** 0.099 0.002 -0.276*** -0.018*** 0.085
(2.15) (-18.83) (-5.95) (1.53) (-16.19) (-4.14)
0.000 -0.275*** 0.001 -0.110*** 0.117 -0.001 -0.268*** 0.005 -0.109*** 0.101
(0.07) (-17.85) (0.11) (-10.34) (-0.55) (-16.13) (1.02) (-8.37)
XLK (Technology) XLB (Materials)

0.003** -0.221*** -0.025*** 0.061 0.002* -0.284*** -0.030*** 0.097
(2.28) (-11.56) (-4.90) (1.79) (-16.43) (-6.08)
0.000 -0.207*** -0.003 -0.104*** 0.077 0.000 -0.275*** 0.007 -0.084*** 0.111
(0.32) (-11.14) (-0.57) (-7.54) (-0.01) (-15.81) (1.16) (-8.40)
XLP (Consumer Staples) XLE (Energy)

0.004*** -0.341*** -0.040*** 0.140 0.001 -0.198*** -0.020*** 0.048
(2.69) (-23.62) (-7.44) (1.15) (-11.88) (-4.72)
0.000 -0.329*** 0.003 -0.113*** 0.153 0.000 -0.193*** 0.012** -0.072*** 0.065
(-0.13) (-22.59) (0.42) (-9.12) (-0.36) (-11.77) (2.28) (-9.27)
XLU (Utilities)
0.002 -0.309*** -0.043*** 0.120
(1.46) (-18.53) (-7.62)
0.000 -0.295*** -0.003 -0.090*** 0.133
(0.20) (-17.59) (-0.40) (-8.22)
28

Table 5: Correlation and Volatility Forecast Error
The correlation forecast error for sector K at time t, denoted as ρεKt , is calculated as implied correlation based
on information at the close of day t less realized average correlation during the interval [t+1 day, t+30 days].
Realized average correlation is the constant pairwise correlation that equates observed volatility on the
sector ETF during this interval with the volatility of the underlying portfolio, where sector weights are
ε
measured using market caps at the end of day t. Volatility forecast error is denoted σKt and is measured as
log(IVKt /RVKt ), where IVKt is the implied volatility from the sector ETF option at the close of t, and RVKt
is realized volatility on the sector ETF during the following 30 calendar days. We estimate the following
models using the Newey and West (1987) method and allowing for five lags:
ρεKt = α + β1 uKt + εKt (Model 1)

ρεKt = α + β1 uKt + β2 ρ̃Kt + β3 σ̃Kt + εKt (Model 2)
ε
σKt = α + β1 uKt + β2 ρ̃Kt + β3 σ̃Kt + εKt (Model 3)
where uKt is the abnormal sector correlation premium, ρ̃Kt is the level of the sector correlation premium,
and σ̃Kt is the level of the sector volatility premium. Coefficient estimates are shown with t-statistics below
in parentheses.
XLF XLI XLK XLP XLU XLV XLY XLB XLE

Panel A: Model 1
α 0.045 0.016 0.030 0.005 -0.059 0.001 0.009 0.000 -0.013
(9.67) (3.04) (6.69) (0.92) (-11.34) (0.14) (1.86) (0.07) (-2.63)
β1 0.628 0.388 0.638 0.504 0.534 0.494 0.503 0.503 0.589
(21.27) (11.17) (20.89) (15.55) (17.81) (13.01) (12.06) (16.64) (19.32)
R2 0.254 0.091 0.241 0.178 0.248 0.141 0.119 0.180 0.265
Panel B: Model 2
α 0.051 0.014 0.030 0.002 -0.092 0.000 0.006 0.002 -0.010
(9.509) (2.63) (6.13) (0.37) (-4.75) (0.08) (1.00) (0.39) (-1.87)
β1 0.613 0.408 0.529 0.645 1.075 0.564 0.388 0.725 0.602
(8.37) (5.78) (10.04) (8.00) (3.89) (7.49) (6.19) (8.29) (6.08)
β2 0.130 -0.040 0.155 -0.194 -0.533 -0.076 0.086 -0.220 0.042
(1.66) (-0.53) (2.73) (-2.22) (-1.87) (-0.92) (1.34) (-2.38) (0.401)
β3 -0.131 0.023 -0.051 0.044 -0.008 0.005 0.028 -0.001 -0.064
(-5.02) (0.68) (-2.00) (1.55) (-0.31) (0.15) (0.92) (-0.04) (-2.15)
R2 0.275 0.092 0.246 0.182 0.251 0.142 0.126 0.185 0.268
Panel C: Model 3
α 0.095 0.090 0.100 0.076 -0.009 0.085 0.090 0.049 0.039
(7.86) (9.29) (9.28) (6.91) (-0.27) (6.79) (8.03) (5.08) (4.10)
β1 0.433 0.245 0.579 0.733 0.863 0.471 0.460 0.653 0.460
(2.67) (2.08) (4.82) (4.64) (1.68) (3.05) (3.48) (4.27) (2.49)
β2 -0.009 0.147 0.027 -0.383 -0.606 0.060 -0.052 -0.447 0.017
(-0.05) (1.02) (0.21) (-2.18) (-1.17) (0.33) (-0.37) (-2.78) (0.08)
β3 -0.019 -0.052 0.040 0.231 0.299 0.091 0.143 0.208 0.090
(-0.33) (-0.83) (0.76) (3.95) (6.09) (1.37) (2.21) (3.50) (1.56)
R2 0.032 0.024 0.067 0.100 0.119 0.066 0.046 0.064 0.102
29

Table 6: Trading Strategy Average Daily Profits
This table presents average daily profits to four trading strategies for each of the nine sectors. All of
the trading strategies hold long (short) straddles in 30-day at-the-money sector ETF options and short
(long) straddles in 30-day at-the-money SPY options when a buy (sell) signal is generated. The LvlVolPrem
strategy generates a buy (sell) when the sector volatility premium is below (above) its historical average. The
LvlCorrPrem strategy generates a buy (sell) signal when the sector correlation premium is below (above) its
historical average. The AbVolPrem generates a buy (sell) signal when the sector volatility premium is below
(above) its typical relation to the SPY volatility premium. The AbCorrPrem generates a buy (sell) signal
when the sector correlation premium is below its typical relation to the SPY correlation premium. Newey
and West (1987) t-statistics assuming five lags are shown below daily profits in parentheses. Significance at
the 10%, 5%, and 1% levels are indicated by *, **, ***, respectively.
Sector LvlVolPrem LvlCorrPrem AbVolPrem AbCorrPrem

XLB 658.41*** 1507.19*** 1378.42*** 1735.44***
(2.731) (6.086) (5.637) (7.027)
XLF 615.95* 2921.56*** 2117.82*** 3703.81***
(1.783) (7.961) (6.304) (9.959)
XLE 275.89 1106.04*** 716.77*** 1570.95***
(1.071) (4.243) (2.838) (5.787)
XLI 386.46** 1005.72*** 1589.84*** 1925.07***
(2.153) (5.441) (8.304) (9.815)
XLP 850.90*** 1476.47*** 1223.65*** 2030.02***
(3.255) (5.511) (4.689) (7.416)
XLU 593.60* 1216.71*** 962.01*** 1403.07***
(1.931) (3.944) (3.122) (4.564)
XLV 668.29*** 1064.52*** 1187.42*** 1738.79***
(2.829) (4.685) (5.052) (7.425)
XLY 390.63** 951.03*** 1203.44*** 1708.33***
(2.179) (4.790) (5.937) (8.158)
XLK 1066.34*** 2438.35*** 2083.40*** 3255.82***
(3.515) (6.989) (6.641) (9.167)
30

Table 7: Comparing the Profitability of the Information from the Four Signals
This table compares to daily profits generated by the four trading strategies. To do so, we difference the
time series of daily profits and then compute the average daily difference along with the Newey and West
(1987) t-statistic assuming five lags in parentheses. Significance at the 10%, 5%, and 1% levels are indicated
by *, **, ***, respectively.
Sector AbVolPrem - AbCorrPrem - LvlCorrPrem - AbCorrPrem -

LvlVolPrem LvlCorrPrem LvlVolPrem AbVolPrem
XLB 720.02*** 228.25* 848.79*** 357.02
(4.413) (1.904) (3.636) (1.479)
XLF 1501.87*** 782.25*** 2305.61*** 1585.99***
(4.636) (3.061) (5.113) (3.494)
XLE 440.88** 464.91*** 830.15*** 854.18***
(2.251) (2.933) (2.821) (2.820)
XLI 1203.38*** 919.34*** 619.26*** 335.23*
(5.807) (5.026) (3.087) (1.732)
XLP 372.75 553.55*** 625.57** 806.37***
(1.396) (3.273) (2.272) (3.178)
XLU 368.41* 186.37 623.10* 441.06
(1.697) (1.315) (1.886) (1.372)
XLV 519.14** 674.28*** 396.23 551.37***
(2.126) (3.476) (1.622) (2.543)
XLY 812.81*** 757.30*** 560.40*** 504.89***
(4.441) (3.902) (3.525) (2.853)
XLK 1017.05*** 817.47*** 1372.00*** 1172.42***
(3.980) (3.919) (4.345) (3.767)
31

Table 8: Trading Strategy Profits Pre-Crisis (1998–2008)
This table provides the average daily dollar profit to each of the trading strategies (Panel a) and various measures of incremental profits (Panel b)
during the first subperiod spanning 1998–2008. The trading strategies are described in Table 6. Newey and West (1987) t-statistics assuming five
lags are shown below daily profits in parentheses. Significance at the 10%, 5%, and 1% levels are indicated by *, **, ***, respectively.
Panel (a): Average Daily Profit Panel (b): Comparing Average Daily Profits
AbVolPrem - AbCorrPrem - LvlCorrPrem - AbCorrPrem -

Sector LvlVolPrem LvlCorrPrem AbVolPrem AbCorrPrem LvlVolPrem LvlCorrPrem LvlVolPrem AbVolPrem
XLB 1229.55*** 2623.37*** 1912.92*** 2545.99*** 683.366*** -77.3759 1393.81*** 633.071

(2.76) (5.69) (4.17) (5.60) (2.46) 0.39 (3.33) (1.49)
XLF 865.716 3294.41*** 2054.48*** 3779.05*** 1188.77*** 484.647 2428.69*** 1724.57***
(1.55) (6.10) (3.92) (6.73) (2.52) (1.41) (3.48) (2.45)
32
XLE 539.586 1880.93*** 1017.28*** 2259.2*** 477.691 378.27*** 1341.34 1241.92***
(1.22) (4.05) (2.30) (4.83) (1.57) (2.00) (1.22) (4.05)
XLI 796.358*** 1691.65*** 2287.9*** 2679.73*** 1491.55**** 988.074*** 895.296*** 391.825
(2.43) (4.77) (6.52) (7.62) (4.22) (3.02) (2.29) (1.19)
XLK 2427.9*** 4875.47*** 3773.36*** 5962.78*** 1345.47*** 1087.31*** 2447.57*** 2189.42***
(3.60) (5.97) (5.37) (7.15) (2.59) (2.81) (3.36) (3.11)
XLP 1824.22*** 2508.53*** 1990.63*** 2916.41*** 166.412 407.879 684.311 925.779***
(3.86) (5.16) (4.36) (6.02) (0.35) (1.44) (1.37) (2.11)
XLU 1849.26*** 1857.52*** 2122.58*** 1978.73*** 273.32 121.213 8.26301 -143.844
(3.32) (3.30) (3.86) (3.51) (0.82) (0.69) (0.01) 0.26

XLV 1153.23*** 1537.14*** 1895.79*** 2257.2*** 742.558 720.06*** 383.916 361.418
(2.74) (3.85) (4.38) (5.46) (1.64) (2.28) (0.88) (1.01)
XLY 1038.89*** 1783.48*** 1808.23*** 2737.37*** 769.337*** 953.897*** 744.584*** 929.144***
(2.95) (4.51) (4.54) (6.51) (2.27) (2.59) (2.49) (2.72)
Table 9: Trading Strategy Profits Post-Crisis (2009–2018)
This table provides the average daily dollar profit to each of the trading strategies (Panel a) and various measures of incremental profits (Panel b)
during the latter subperiod spanning 2009-2018. The trading strategies are described in Table 6. Newey and West (1987) t-statistics assuming five
lags are shown below daily profits in parentheses. Significance at the 10%, 5%, and 1% levels are indicated by *, **, ***, respectively.
Average Daily Profit Comparing Average Daily Profits
AbVolPrem - AbCorrPrem - LvlCorrPrem - AbCorrPrem -

Sector LvlVolPrem LvlCorrPrem AbVolPrem AbCorrPrem LvlVolPrem LvlCorrPrem LvlVolPrem AbVolPrem
XLB 100.509 555.361*** 1103.74*** 1310.47*** 1003.23*** 755.107*** 454.852** 206.726

(0.47) (2.63) (5.13) (5.95) (4.08) (3.93) (1.82) (0.86)
XLF 437.512 1858.48*** 2035.67*** 3313.29*** 1598.15*** 1454.81*** 1420.97*** 1277.62***
(1.07) (4.26) (5.13) (7.65) (3.36) (3.36) (2.89) (2.68)
33
XLE 142.223 378.462 927.146*** 1213.01*** 784.924*** 834.548*** 236.239 285.863
(0.55) (1.46) (3.52) (4.36) (2.75) (2.91) (0.83) (0.91)
XLI -3.4897 285.108** 1045.46*** 1320.12*** 1048.95*** 1035.01*** 288.598 274.655
(-0.02) (1.86) (6.27) (7.61) (4.79) (5.29) (1.52) (1.35)
XLK 52.7459 654.411*** 897.231*** 1356.11*** 844.485*** 701.7*** 601.665*** 458.879***
(0.29) (3.92) (4.63) (6.76) (4.09) (3.44) (3.03) (2.12)
XLP 37.2933 745.814*** 866.042*** 1811.65*** 828.748*** 1065.83*** 708.52*** 945.606***
(0.15) (2.96) (3.30) (6.51) (3.22) (3.93) (2.76) (3.44)
XLU -470.639 428.928 -175.251 853.099*** 295.388 424.171 899.568*** 1028.35***
(-1.51) (1.41) (-0.55) (2.69) (1.03) (1.60) (2.90) (3.25)

XLV -151.633 461.993*** 608.133*** 1230.53*** 759.766*** 768.537*** 613.626*** 622.397***
(-0.72) (2.10) (2.76) (5.61) (3.11) (2.93) (2.54) (2.77)
XLY -130.454 170.792 442.1*** 922.832*** 572.554*** 752.039*** 301.246** 480.731***
(-0.80) (1.09) (2.83) (5.66) (2.96) (4.28) (1.93) (2.80)
Figure 1: Implied Volatility and the Correlation Premium
(a) SPY (b) XLF (Financials)

1.5 Implied Volatility
Implied Volatility
Correlation Premium Correlation Premium
1
1
0.5
0.5
0 0
-0.5
2000 2002 2004 2006 2008 2010 2012 2014 2016 2018 2000 2002 2004 2006 2008 2010 2012 2014 2016 2018
(c) XLI (Industrials) (d) XLK (Technology)

Implied Volatility 1 Implied Volatility
1 0.8
0.6
0.5 0.4
0.2
0 0
-0.2
2000 2002 2004 2006 2008 2010 2012 2014 2016 2018 2000 2002 2004 2006 2008 2010 2012 2014 2016 2018
(e) XLP (Consumer Staples) (f) XLU (Utilities)

0.5
Implied Volatility Implied Volatility
0.5
0 0
-0.5
-0.5
2000 2002 2004 2006 2008 2010 2012 2014 2016 2018 2000 2002 2004 2006 2008 2010 2012 2014 2016 2018
(g) XLV (Health Care) (h) XLY (Consumer Discretionary)

Implied Volatility 0.8 Implied Volatility
0.8
0.6 0.6
0.4
0.4
0.2
0.2
0
0
-0.2
-0.4 -0.2
-0.6 -0.4
2000 2002 2004 2006 2008 2010 2012 2014 2016 2018 2000 2002 2004 2006 2008 2010 2012 2014 2016 2018
(i) XLB (Materials) (j) XLE (Energy)

1
Implied Volatility 1 Implied Volatility
0.5 0.5
0 0
-0.5
-0.5
2000 2002 2004 2006 2008 2010 2012 2014 2016 2018 2000 2002 2004 2006 2008 2010 2012 2014 2016 2018
34

Figure 2: Cumulative Profits of Level Trading Strategy (Full Sample)
(a) XLB (b) XLE (c) XLF
(d) XLI (e) XLK (f) XLP
(g) XLU (h) XLV (i) XLY
35

Figure 3: Cumulative Profits of Abnormal Trading Strategy (Full Sample)
36

Figure 4: Correlation of Daily Buy/Sell Trading Signals Across Sectors
(a) Level Vol (b) Level CIX
(c) Abnormal Vol (d) Abnormal CIX
37

Figure 5: Correlation of Daily Trading Strategy P&L Across Sectors
(a) Level Vol (b) Level CIX
(c) Abnormal Vol (d) Abnormal CIX
38

Figure 6: Cumulative Profits of Abnormal Trading Strategy Pre-Crisis (1998–2008)
39

Figure 7: Cumulative Profits of Abnormal Trading Strategy Post-Crisis (2009–2018)
40

Abnormal Sector Option Correlation Premiums and Predictable Changes in Implied Volatility

Uploaded by

Document Information

Original Description:

Original Title

Copyright

Available Formats

Share this document

Share or Embed Document

Sharing Options

Did you find this document useful?

Is this content inappropriate?

Copyright:

Available Formats

Abnormal Sector Option Correlation Premiums and Predictable Changes in Implied Volatility

Uploaded by

Copyright:

Available Formats

Abnormal Sector Option Correlation Premiums and

Predictable Changes in Implied Volatility∗

Electronic copy available at: https://ssrn.com/abstract=3862777

depends are on average approximately rational forecasts.

Electronic copy available at: https://ssrn.com/abstract=3862777

investors demand compensation, which is manifest as a negative correlation premium.3 Shocks

Electronic copy available at: https://ssrn.com/abstract=3862777

profitability of trading strategies based on abnormal correlation premium. Section 5 summarizes

the contribution of this research and provides concluding remarks.

2 Background and Related Literature

Electronic copy available at: https://ssrn.com/abstract=3862777

to recover a complete heterogeneous correlation matrix and restrictive identifying assumptions

in stock correlations. Whether a separate correlation risk premium is priced in equilibrium or is

wholly redundant relative to measures of volatility.4

Electronic copy available at: https://ssrn.com/abstract=3862777

variables such as the volatility premium.

correlation and volatility and premiums.

Electronic copy available at: https://ssrn.com/abstract=3862777

that details the nine sectors.

the individual stocks and ETF shares.

Electronic copy available at: https://ssrn.com/abstract=3862777

nine sector options and options on SPY.

In addition to forward-looking implied correlation, we also calculate a historical measure of real-

through date t.6

Electronic copy available at: https://ssrn.com/abstract=3862777

the downside risk of long equity portfolios.

Panel B of Table 1 provides information on implied correlations and correlation premiums.

Electronic copy available at: https://ssrn.com/abstract=3862777

that also exhibit the greatest variation in correlation premium.

sectors suggests that it is influenced by forces that may not be rational.

3.2 Implied Correlation Dynamics

Electronic copy available at: https://ssrn.com/abstract=3862777

ρ̃Kt = αK + βK ρ̃SP Y,t + uKt (3)

σ̃Kt = αK + βK σ̃SP Y,t + vKt (4)

Electronic copy available at: https://ssrn.com/abstract=3862777

∆ρKt = αK + β1K ∆ρKt−1 + β2K ρ̃Kt−1 + β3K uKt−1 + εKt (5)

Electronic copy available at: https://ssrn.com/abstract=3862777

to the SPY correlation premium.

the following similar model:

∆IVKt = α + β1K ∆IVKt−1 + β2K σ̃Kt−1 + β3K uKt−1 + εKt (6)

typical relative valuation.

Electronic copy available at: https://ssrn.com/abstract=3862777

implied correlation to be an unbiased estimate of future realized correlation. In models of index

associated with implied correlation relative to recent historically realized correlation.

t to realized volatility during [t + 1, t + 30].

we estimate the following two models:

ρεKt = α + β1 uKt + εKt (7)

ρεKt = α + β1 uKt + β2 ρ̃Kt + β3 σ̃Kt + εKt (8)

dominates as a signal that implied correlation may be too high.

Electronic copy available at: https://ssrn.com/abstract=3862777

add little to the explanatory power of the abnormal correlation premium.

Electronic copy available at: https://ssrn.com/abstract=3862777

Electronic copy available at: https://ssrn.com/abstract=3862777

exploiting the predictability documented above.

Electronic copy available at: https://ssrn.com/abstract=3862777

4.2 Profitability of Trading Strategies

Electronic copy available at: https://ssrn.com/abstract=3862777

conclusion by examining the performance of these trading strategies within subperiods.

Electronic copy available at: https://ssrn.com/abstract=3862777

correlation premium constitutes the dominant trading signal.

Electronic copy available at: https://ssrn.com/abstract=3862777

across the sectors.

XLI -0.020* 0.823* 0.296 -0.023* 0.795* 0.629

XLK -0.007* 0.894* 0.348 -0.006 0.790* 0.590

XLP -0.021* 0.631* 0.154 0.001 0.664*** 0.360

XLU -0.071* 0.152* 0.007 -0.023* 0.442* 0.177

XLV -0.029* 0.707* 0.234 -0.013 0.764* 0.510

XLY -0.030* 0.855* 0.410 -0.008 0.772*** 0.607

XLB -0.019* 0.612* 0.129 -0.032* 0.618* 0.395

XLE -0.032* 0.481* 0.082 -0.034* 0.546* 0.348

XLB 1229.55* 2623.37* 1912.92* 2545.99* 683.366* -77.3759 1393.81* 633.071

XLB 100.509 555.361* 1103.74* 1310.47* 1003.23* 755.107* 454.852 206.726