Option-implied correlation between iTraxx Europe Financials and Non-Financials Indexes: A measure of spillover effect in European debt crisis

- Option-implied correlation in CDS indexes is estimated by a basket-option model.
- Correlation between iTraxx Financials and Non-Financials Indexes is estimated.
- Option-implied correlation measures the spillover in the European debt crisis.
- Information flow was from option-implied correlation to realized correlation.
- Sovereign and funding liquidity risks are determinants of the correlation.

This paper proposes an analytic method to estimate the option-implied correlation embedded in options on the iTraxx Europe CDS indexes. The option-implied correlation is suggested as a measure of the spillover effect of default risk between the financial and corporate sectors in Europe. In particular, the correlation between the iTraxx Financials and Non-Financials sub-indexes is estimated from options on the iTraxx Main Index, which is considered as a basket option with the two sub-indexes being its underlyings. The abrupt changes of the realized correlation anticipated information of the corresponding option prices. The sovereign default risk, funding liquidity risk, level of risk aversion, and equity market performance are identified to be significant determinants of the option-implied correlation, implying inter-dependence amongst various markets during the European debt crisis.