Option-Implied Dependence and Correlation Risk Premium

Oleg Bondarenko and Carole Bernard

We propose a novel model-free approach to obtain the joint risk-neutral distribution among several assets that is consistent with options on these assets and their weighted index. We implement this approach for the nine industry sectors comprising the S&P 500 index and find that their option-implied dependence is highly asymmetric and timevarying. We then study two conditional correlations: when the market moves down or up. The risk premium is strongly negative for the down correlation but positive for the up correlation. Intuitively, investors dislike the loss of diversification when markets fall, but they actually prefer high correlation when markets rally.