Forward looking up-/down correlations

Wolfgang Schadner; Wolfgang Schadner

doi:10.3934/QFE.2021021

Quantitative Finance and Economics

2021, Volume 5, Issue 3: 471-495. doi: 10.3934/QFE.2021021

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Research article

Forward looking up-/down correlations

Wolfgang Schadner ^,

Swiss Institute of Banking and Finance, University of St.Gallen, St. Gallen, Switzerland

Received: 25 March 2021 Accepted: 27 May 2021 Published: 03 June 2021
JEL Codes: C58, G11, G17

Equity returns are typically higher correlated during market downturns than during bullish times. This paper develops a novel approach how investor expectations for such correlation asymmetries can be quantified from forward-looking data. Based on option implied volatilities, it is found that the correlation asymmetry is significant, rejecting the use of the classic mono-correlation assumption. Further, the spread between expected down and up correlations is time-varying and positively dependent on the current market mood: stock diversification is more difficult when it is needed the most. Thus, the three main advantages of the proposed model are (ⅰ) the distinction between up- and down-correlations, (ⅱ) it actually captures investor expectations as traded in current market prices and (ⅲ) the immediate response to the current market outlook. Practical relevance of this paper is highlighted by the computation of expected up-/down CAPM betas.
- implied correlation,
- Dual-Beta,
- implied volatility,
- forward-looking risk,
- asymmetric dependence
Citation: Wolfgang Schadner. Forward looking up-/down correlations[J]. Quantitative Finance and Economics, 2021, 5(3): 471-495. doi: 10.3934/QFE.2021021

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Abstract

Equity returns are typically higher correlated during market downturns than during bullish times. This paper develops a novel approach how investor expectations for such correlation asymmetries can be quantified from forward-looking data. Based on option implied volatilities, it is found that the correlation asymmetry is significant, rejecting the use of the classic mono-correlation assumption. Further, the spread between expected down and up correlations is time-varying and positively dependent on the current market mood: stock diversification is more difficult when it is needed the most. Thus, the three main advantages of the proposed model are (ⅰ) the distinction between up- and down-correlations, (ⅱ) it actually captures investor expectations as traded in current market prices and (ⅲ) the immediate response to the current market outlook. Practical relevance of this paper is highlighted by the computation of expected up-/down CAPM betas.

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