Average Correlation and Stock Market Returns
Joshua Matthew Pollet
University of Illinois at Urbana-Champaign - Department of Finance
Mungo Ivor Wilson
University of Oxford - Said Business School
November 1, 2008
If the Roll critique is important, changes in the variance of the stock market may be only weakly related to changes in aggregate risk and subsequent stock market excess returns. However, since individual stock returns share a common sensitivity to true market return shocks, higher aggregate risk can be revealed by higher correlation between stocks. In addition, a change in stock market variance that leaves aggregate risk unchanged can have a zero or even negative effect on the stock market risk premium. We show that the average correlation between daily stock returns predicts subsequent quarterly stock market excess returns. We also show that changes in stock market risk holding average correlation constant can be interpreted as changes in the average variance of individual stocks. Such changes have a negative relation with future stock market excess returns.
Number of Pages in PDF File: 43
Keywords: Average correlation, average variance, Roll critique
JEL Classification: G12working papers series
Date posted: March 5, 2008 ; Last revised: December 2, 2008
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