"The Correlation Risk Premium Term Structure"
Gonçalo Faria - Universidade Católica Portuguesa (joint work with Robert Kosowski)
"The aim of this paper is to study the term structure of correlation risk and exploit a unique dataset of correlation swap quotes. The main empirical findings are supported by a general equilibrium asset pricing model that endogenously generates a correlation risk term structure. We analyse two alternative measures of correlation risk and their term structure, based on S&P500 correlation swap quotes and the synthetic correlation swap rates estimated from option prices. Our main empirical findings are supported by a Lucas Orchard type model with heterogeneous agents that differ in their beliefs about the probability of a systemic rare disaster. When the latter occurs, there is an increase in the dispersion in beliefs about expected consumption growth rate and in the consumption share of the more pessimistic agent. This generates a flattening of the term structure for both the risk neutral expected correlation and the correlation risk premium during periods of enhanced uncertainty."
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