Implied Correlation and Market Returns

45 Pages Posted: 29 Feb 2016

Date Written: February 29, 2016

Abstract

This paper provides evidence that the implied correlation is an indicator of market-wide risk. From a time-series approach, we analyze whether aggregate implied correlation contains information on future market returns. We document that it explains an important fraction of the variation in aggregate market excess returns, with high implied correlation inducing an increase in subsequent market returns. The predictive power is stronger at a forecast of quarterly and semi- annual return horizons and is not captured by standard predictors like valuation ratios and business cycle variables. Moreover, we show that the information con- tent of the correlation risk premium and realized correlation on market returns is fully driven by the implied correlation.

Suggested Citation

Bernales, Alejandro and Valenzuela, Marcela, Implied Correlation and Market Returns (February 29, 2016). Available at SSRN: https://ssrn.com/abstract=2739757 or http://dx.doi.org/10.2139/ssrn.2739757

Alejandro Bernales

Universidad de Chile ( email )

República 701
Santiago
Chile

HOME PAGE: http://www.alejandrobernales.com

Marcela Valenzuela (Contact Author)

University of Chile ( email )

Pío Nono Nº1, Providencia
Santiago, R. Metropolitana 7520421
Chile

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