Estimating Option-Implied Correlation between iTraxx Europe Financial and Corporate Sub-Indexes

This paper proposes a model to estimiate option-implied correlation embedded in options on the iTraxx Europe indexes as a measure of the spillover effect of default risk between the financial and corporate sectors in Europe. The correlation structure between the iTraxx Financials and Non-Financials sub-indexes are reflected in the option on the iTraxx Main Index, which is simultaneously considered as a basket option with the two sub-indexes as two correlated underlyings. The spillover effect was found to be more severe during the second half of year 2011, and the abrupt changes of the realized correlation between the CDS indexes of the financial and corporate sectors anticipated information of the corresponding option prices. The sovereign default risk, funding liquidity risk, level of risk aversion, and equity market performance were found to be significant determinants of the option-implied correlation, implying inter-dependence amongst various markets during the European debt crisis.