The correlation risk premium: Term structure and hedging

As the recent financial crisis has shown, diversification benefits can suddenly evaporate when correlations unexpectedly increase. We analyse alternative measures of correlation risk and their term structure, based on S&P500 correlation swap quotes, synthetic correlation swap rates estimated from option prices and the CBOE Implied Correlation Indices. An analysis of unconditional and conditional correlation hedging strategies shows that only some conditional correlation hedging strategies add value. Among the conditional hedge strategy’s conditioning variables we find that the level of the correlation risk factor and dispersion trade returns deliver the best results, while the CBOE Implied Correlation Indices perform poorly.