Expected Correlation and Future Market Returns

53 Pages Posted: 10 Feb 2018 Last revised: 5 Jul 2019

See all articles by Adrian Buss

Adrian Buss

INSEAD - Finance; Centre for Economic Policy Research (CEPR)

Lorenzo Schoenleber

Frankfurt School of Finance & Management gemeinnützige GmbH

Grigory Vilkov

Frankfurt School of Finance & Management

Multiple version iconThere are 2 versions of this paper

Date Written: July 2, 2019

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

Suggested Citation

Buss, Adrian and Schönleber, Lorenzo and Vilkov, Grigory, Expected Correlation and Future Market Returns (July 2, 2019). Available at SSRN: https://ssrn.com/abstract=3114063 or http://dx.doi.org/10.2139/ssrn.3114063

Adrian Buss

INSEAD - Finance ( email )

Boulevard de Constance
Fontainebleau Cedex, 77305
France
+33 160 72 44 84 (Phone)
+33 160 72 40 45 (Fax)

HOME PAGE: http://sites.google.com/view/abuss

Centre for Economic Policy Research (CEPR) ( email )

London
United Kingdom

Lorenzo Schönleber

Frankfurt School of Finance & Management gemeinnützige GmbH ( email )

Adickesallee 32-34
Frankfurt am Main, 60322
Germany

HOME PAGE: http://https://sites.google.com/view/lorenzo-schoenleber/menu

Grigory Vilkov (Contact Author)

Frankfurt School of Finance & Management ( email )

Adickesallee 32-34
Frankfurt am Main, 60322
Germany

HOME PAGE: http://www.vilkov.net

Register to save articles to
your library

Register

Paper statistics

Downloads
444
Abstract Views
1,633
rank
65,268
PlumX Metrics