DP13873 Correlation Risk, Strings and Asset Prices

Author(s): Walter Distaso, Antonio Mele, Grigory Vilkov
Publication Date: July 2019
Keyword(s): arbitrage pricing, correlation premium, correlation-risk premium, cross-section of returns, implied correlation, string models
JEL(s): G11, G12, G13, G17
Programme Areas: Financial Economics
Link to this Page: cepr.org/active/publications/discussion_papers/dp.php?dpno=13873

Standard asset pricing theories treat return volatility and correlations as two intimately related quantities, which hinders achieving a neat definition of a correlation premium. We introduce a model with a continuum of securities that have returns driven by a string. This model leads to new arbitrage pricing restrictions, according to which, holding any asset requires compensation for the granular exposure of this asset returns to changes in all other asset returns: an average correlation premium. We find that this correlation premium is both statistically and economically significant, and considerably fluctuates, driven by time-varying correlations and global market developments. The model explains the cross-section of expected returns and their counter-cyclicality without making reference to common factors affecting asset returns. It also explains the time-series behavior of the premium for the risk of changes in asset correlations (the correlation-risk premium), including its inverse relation with realized correlations.