Understanding the correlation risk premium

Abstract

In this paper, we provide a theoretical framework justifying the existence of a correlation risk premium in a market with two traded assets. We prove that risk-neutral dependence can differ substantially from real-world dependence by characterizing the set of risk-neutral martingale measures. This implies that implied correlation can be significantly different with the realized correlation. Depending on the choice of the market regarding the pricing measure, implied correlation can be high or low. We label the difference between risk-neutral and real-world correlation the “correlation gap” and make the connection with correlation risk premium. We show how dispersion trading can be used to exploit this correlation gap and demonstrate how there can exist a negative correlation risk premium in the financial market.