EOD Implied Correlation Index
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Cboe Implied Correlation Skew Structure (3M)
Cboe Implied Correlation Term Structure (ATM)
What is Implied Correlation?
Implied Correlation, a gauge of herd behavior, is the market’s expectation of future diversification benefits. It measures the average expected correlation between the top 50 stocks in the SPX index. Cboe calculates COR3M by using ATM delta relative constant maturity SPX index and component option implied volatilities.
Why correlation and dispersion?
Correlation quantifies the diversification benefit that any financial investor expects to earn when constructing a portfolio. Decreasing correlation reduces a portfolio's overall volatility beyond the weighted average volatility of portfolio components, improving investor risk/return tradeoffs. Positive correlation spikes indicate lower expected diversification benefits, increased systematic risk, and a higher likelihood of experiencing extreme tail events associated with sudden market movements.
Like correlation, dispersion quantifies diversification benefits by measuring the spread between the average variance of component securities and portfolio variance. Dispersion trading requires investors to observe changes in the level of correlation and estimate the relative cheapness of index options compared to holding a basket of component options.
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Diversification is Not Static
A portfolio’s risk profile can be decomposed into undiversifiable systematic and diversifiable idiosyncratic risks. Investors can avoid excessive risk exposure without sacrificing returns by constructing a large enough portfolio containing diverse securities with various risk drivers.
The SPX index is often considered the optimal target portfolio that provides an investor with a consistent trade-off. However, does the SPX guarantee diversification benefits? Are changes in SPX composition exposing investors to sector idiosyncratic risk? Market participants need a robust indicator measuring the dynamic relationship between index components to form a strong understanding of the inherent risk factors driving the SPX.
Compensation for Holding SPX
The SPX Index risk premium can be computed by comparing the difference between the index’s implied volatility and realized volatility. From historic data, we know that market participants consistently overestimate expected volatility. An explanation of this phenomenon is that the risk premium is compensating investors for market crash risk, an extreme left tail event.
We observe a positive risk premium for SPX and near-zero premiums for individual equities because investors holding the index are concerned about sharp increases in correlation, which evaporates diversification benefits and essentially converts the SPX into a large egg basket holding a series of interconnected risk factors.
Are Premiums Static?
We observe an upward sloping implied correlation term structure during expansionary and stable market periods. This observation indicates that as more time passes, investors attribute higher probabilities to experiencing drawdown shock events. Therefore, investors require higher compensation for holding long volatility and correlation risk positions for a longer time.
Additionally, we observe that the put OTM strike implied correlations were higher than ATM values, and call OTM strike implied correlations were lower than ATM values, forming a skew. This indicates that market participants want higher compensation for taking on left-tail crash risk than right-tail risk, and higher correlation levels are expected during drawdown periods.
Drivers of SPX Implied Correlation
Market participants can identify factors influencing the SPX implied correlation by looking specifically at correlation levels between and within SPX sector portfolios.
Sector implied correlation allows investors to isolate SPX individual risk by separating systematic market risk from industry-level risks. Comparing correlation and risk premiums across industries, we observed lower premiums for Utilities and Health Care and higher premiums for Energy and Finance.
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