Expected Correlation and Future Market Returns
45 Pages Posted: 10 Feb 2018 Last revised: 19 Dec 2018
Date Written: December 17, 2018
We document that information about the comovement of individual stocks, jointly extracted from index options and individual stock options, can be used to predict future market excess returns for horizons of up to 1 year, both in-sample and out-of-sample. The predictive power is incremental to that of risk measures exclusively based on the marginal distribution of the market, including (semi)variances and their risk premiums. We attribute this predictability to the ability of expected correlation to capture expected variations in idiosyncratic risk and in the cross-sectional dispersion in systematic risk. A novel extension of the contemporaneous-beta approach significantly improves out-of-sample predictability.
Keywords: expected (implied) correlation, correlation risk premium, return predictability, idiosyncratic risk, option-implied information, contemporaneous betas
JEL Classification: G11, G12, G13, G17
Suggested Citation: Suggested Citation