Expected Correlation and Future Market Returns

Abstract

Implied correlation, jointly extracted from index and stock options, is a robust predictor of long-term market returns. We document that its predictive power stems from its role as a leading procyclical state variable, predicting future investment opportunities, that is, financial-market risks and macroeconomic conditions, for up to 18 months ahead. The predictability is inherited from the interplay between its three main components --- implied market variance, implied idiosyncratic variance, and the implied dispersion of market betas --- and not subsumed by measures of tail risk. We also provide first empirical evidence of out-of-sample predictability, leading to substantial economic gains for market-timing strategies.

Keywords: (option-)implied correlation, return predictability, idiosyncratic risk, option-implied information, contemporaneous betas

JEL Classification: G11, G12, G13, G17