Ex-Ante Risk Factors and Required Structures of the Implied Correlation Matrix

Wolfgang Schadner

Finance Research Letters, 2021, vol. 41, issue C

Abstract: This paper develops a method to improve estimation accuracy of the equity implied correlation matrix. The advantages of implied versus historical correlations are (i) that they actually reflect investor expectations and (ii) they are able to adopt for sudden changes in the market. While the complete solution to the matrix remains impossible, we address the puzzle from a factor pricing perspective and argue that certain structures are obligatory. Given so, the matrix can be refined into clusters of similar firm characteristics where coefficients are assessable. This allows to enhance the estimation precision while keeping the benefits from being fully forward-looking.

Keywords: Implied Correlation; Equity; Expected Risk; Risk Factors; Option Implied Volatility (search for similar items in EconPapers)
JEL-codes: C58 G12 (search for similar items in EconPapers)
Date: 2021
References: View references in EconPapers View complete reference list from CitEc
Citations: View citations in EconPapers (2)

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Persistent link: https://EconPapers.repec.org/RePEc:eee:finlet:v:41:y:2021:i:c:s154461232031669x

DOI: 10.1016/j.frl.2020.101855

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