Expected Correlation and Future Market Returns
53 Pages Posted: 10 Feb 2018 Last revised: 5 Jul 2019
Date Written: July 2, 2019
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
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