Correlations, Value Factor Returns, and Growth Options
83 Pages Posted: 15 Nov 2019 Last revised: 15 Mar 2020
Date Written: November 6, 2019
Ex ante (expected) average equity market correlation is linked to the differential correlation dynamics of growth and value firms, as well as the value premium. It predicts returns on the value factor, returns of growth firms, and the changes in growth options within an economy for horizons up to one year. A production-based asset-pricing model supports the existence of a homogeneous correlation among stocks with similar growth characteristics, depending on the prevailing idiosyncratic firm variance, increasing in the value of growth options and, hence, is connected to the value premium. Due to its link to growth options and the value premium, implied correlation serves as a leading procyclical state variable. Value Index--based implied correlations improve the predictability of value-related factors.
Keywords: option-implied correlations, production model, value premium, present value of growth options, factor return predictability, option-implied information, trading strategy, diversification, factor risk
JEL Classification: G11, G12, G13, G17
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