A0204
Title: Measuring downside option-implied correlation
Authors: Zhenxiong Li - Soochow University (China)
Rodrigo Hizmeri - University of Liverpool (United Kingdom)
Xingzhi Yao - Xi\'an Jiaotong Liverpool University (China) [presenting]
Marwan Izzeldin - Lancaster University (United Kingdom)
Abstract: A new decomposition is proposed of the option-implied correlation in terms of its upside and downside components using the out-of-the-money call and put options. The two components are closely associated with diversification benefits when the market rallies and falls. Implementing the decomposition with a large panel of S\&P 500 stocks during 1996-2021, it is shown that the downside implied correlation is the key component of the implied correlation and that the downside correlation risk premium is the main contributor to the correlation risk premium. In addition, it is found that the averaged downside implied correlation exhibits superior forecasting power for future aggregate market returns, which also stays significant after controlling for a number of fundamental market return predictors. Furthermore, option-implied market beta is obtained using pairwise implied correlations at the stock level and strong evidence is established for the important pricing implications of the downside implied beta even after the inclusion of the additional controls. To evaluate the economic significance of decomposition, pairs trading strategies are constructed and the use of downside implied correlation is shown to substantially improve the performance of the strategies.
