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Volatility risk premia of individual and index options represent compensation for the priced disagreement risk. CBOE Implied Correlation Indices perform poorly. After a description of our model, we implement a dispersion trading in the EuroStoxx 50. Secondly, I had a research project on Correlation trades especially involving Correlation Swaps and Dispersion Trades. In this paper we study one of dispersion trading strategies, which attempts to profit from mispricing of the implied volatility of the index compared to implied volatilities of its individual constituents. This thesis tries to explore the profitability of the dispersion trading strategies. Trading vehicle are options on stocks from this index and also options on index itself. We begin examining the different methods proposed to price variance swaps.


The dispersion trading uses known fact that difference between implied and realized volatility is greater between index options than between individual stock option. The high difference between implied volatility of index options and subsequent realized volatility is a known fact. The South African derivatives market is fairly advanced, however it still experiences inefficiencies and dispersion trades have been known to perform well in inefficient markets. As a consequence, the volatility risk premium of the index is larger or smaller than the individual. We also discuss the timing of the method and future developments and improvements. In equilibrium, the skewness of the individual stocks and the index differ due to a correlation risk premium. We analyze the profile of a systematic short method of a variance swap on this index while being long the constituents.


Previous studies have attributed the profits to dispersion trading to the correlation risk premium embedded in index options. Dispersion trading is a sort of correlation trading as trades are usually profitable in a time when the individual stocks are not strongly correlated and losses money during stress periods when correlation rises. P500 correlation swap quotes, synthetic correlation swap rates estimated from option prices and the CBOE Implied Correlation Indices. The main idea was to apply the fact that dispersion trades and correlation swaps are both ways to have exposure on correlation, but with different risk factors. We have developed a model that explains why the dispersion trading arises and what the main drivers are. An analysis of unconditional and conditional correlation hedging strategies shows that only some conditional correlation hedging strategies add value.


Trades routinely exploit this difference by selling options with consecutive delta hedging. Thus, the goal of the research was to find an effective hedging method that can protect the fund under unfavorable market conditions. Each month, investor sorts stocks based into quintiles based on the size of belief disagreement. Research shows that option excess returns reflect the different exposure to disagreement risk. Investors who buy options of firms which are more prone to heterogeneity in beliefs are compensated in equilibrium for holding this risk. As the recent financial crisis has shown, diversification benefits can suddenly evaporate when correlations unexpectedly increase.


In particular, I have automated the analysis through VBA in Excel. Thus, taking these two products and taking opposite positions in the two, we try to achieve a hedging effect. This paper tests the South African market for dispersion opportunities and explores various methods of executing these trades. While correlation swap has a pure exposure to correlation, dispersion trade has exposure to the realised volatilities as well as the correlation of the components. Empirical implementation of our model also indicates that the index variance risk premium can be attributed to the high price of correlation risk. Lyxor has been benefiting from taking short positions on Dispersion Trades through variance swaps, thanks to the fact that empirically the index variance trades rich with respect to the variance of the components. This report is to summarize the research I have conducted in this subject.


The natural alternative hypothesis argues that the profitability results from option market inefficiency. The purpose was to anticipate the profit and to know when and how to reallocate assets according to the market conditions. Institutional changes in the options market in late 1999 and 2000 provide a natural experiment to distinguish between these hypotheses.

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