Implied Correlation and Market Returns

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.