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Cboe Global Markets

Market Expectations About Future Diversification Benefits

Accounting for the implied volatility relationship between the SPX index option and a weighted basket portfolio of single-stock options, Cboe S&P 500 Implied Correlation Index measures the market’s expectations of index component correlation.

EOD Implied Correlation Index

What is Implied Correlation?

Implied Correlation, a gauge of herd behavior, is the market’s expectation of future diversification benefits. It specifically measures the average expected correlation between the top 50 stock in the SPX index. It is calculated by using ATM delta relative constant maturity SPX index and component option implied volatilities.

Why correlation and dispersion?

Correlation measures the diversification benefit that any financial investor can obtain when constructing a portfolio. Low correlation reduces a portfolio’s overall volatility beyond the weighted average volatility of the portfolio’s component stocks, such that the investor can realize a better risk/return tradeoff. Positive spikes in correlation not only reduce an investor’s realized diversification benefits but also indicates higher systemic risk. Finally, correlation quantifies the likelihood of experiencing extreme tail events associated with sudden market movements. Like correlation, dispersion quantifies diversification benefits by measuring the spread between the average variance of component securities and portfolio variance. Dispersion allows investors to observe changes in the level of correlation and estimate the relative cheapness of index options compared to holding a basket of component options.

View the Implied Correlation Index dashboard.

Implied Correlation Index Dashboard

Diversification is Not Static

In financial markets, a portfolio’s risk profile can be broken down into systematic factors and diversifiable idiosyncratic risks. To avoid excessive risk exposure an investor can minimize risk without sacrificing returns by constructing a large enough portfolio containing diverse securities with different risk drivers.

Financial practitioners consider the SPX index as the optimum target portfolio that can provide investors with the best consistent risk-return profile. However, does the SPX index really guarantee diversification benefits for all risk types? This can be answered by looking closely at the relationships between index components and how they evolve because of changes in correlation.

Compensation for Holding SPX

The SPX Index risk premium can be computed by comparing the difference between the index’s implied volatility and realized volatility. From historic data, we know that market participants consistently overestimate expected volatility. An explanation of this phenomenon is that the risk premium is compensating investors for market crash risk, an extreme left tail event.

We observe a positive risk premium for SPX and near-zero premiums for individual equities because investors holding the index are concerned about sharp increases in correlation, which evaporates diversification benefits and essentially converts the SPX into a large egg basket holding a series of interconnected risk factors.

Are Premiums Static?

Calculating market expectations of correlation across various maturities, we observed an upward sloping implied correlation term structure during normal market periods. Based on this observation, as time passes, investors predict with a higher likelihood that a large market drawdown will potentially occur. As a result, investors want higher compensation for holding a position that is long volatility and a correlation risk for a longer period of time.

Additionally, we calculated the implied correlation index for different options strikes and observed that the low strike implied correlations were higher than ATM values, and high strike implied correlations were lower than ATM values, forming a skew. Therefore, market participants want higher compensation for taking on larger left tail crash risk relative to right tail risk, and higher correlation levels are expected under large market drawdown periods.

Drivers of SPX Implied Correlation

Market participants can identify factors influencing the SPX implied correlation by looking specifically at correlation levels between and within SPX sector portfolios. Sector implied correlation allows us to isolate and track individual risk factors within the SPX, separating general systematic market risk from industry level risks. By comparing correlation, risk premiums across sectors and with the SPX implied correlation, we can sector market participants believed to be more cyclical. Based on this comparison, we observed lower premiums for sector like Utilities and Health Care, and higher premiums for sectors like Energy and Finance.

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