We study whether exposure to marketwide correlation shocks affects expected option returns, using data on S&P100 index options, options on all components, and stock returns. We find evidence of priced correlation risk based on prices of index and individual variance risk. A trading strategy exploiting priced correlation risk generates a high alpha and is attractive for CRRA investors without frictions. Correlation risk exposure explains the cross‐section of index and individual option returns well. The correlation risk premium cannot be exploited with realistic trading frictions, providing a limits‐to‐arbitrage interpretation of our finding of a high price of correlation risk.
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Driessen et al. (2009) studied this question.
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