Correlations, Value Factor Returns, and Growth Options

Abstract

This paper shows theoretically and empirically that the average equity correlation is related to investment-specific technology (IST) shocks and to growth options. Average equity correlation forecasts returns on growth stocks and returns on the value factor. A production-based asset-pricing model motivates the findings and provides a novel explanation for the market return predictability by average equity correlation: Innovation, e.g., IST shocks, favors individual growth option accumulation and leads to lower average equity correlations. The expected average equity correlation is related to risks associated with the value premium and growth option dynamics and therefore serves as a leading procyclical state variable.

Keywords: Option-implied correlations, investment-specific technology shocks, present value of growth options, value premium, factor return predictability, option-implied information

JEL Classification: G11, G12, G13, G17