Correlations, Value Factor Returns, and Growth Options

Abstract

This paper shows empirically and theoretically that the average equity correlation forecasts returns on growth stocks and returns on the value factor. Innovation, such as IST shocks, favors growth option accumulation, leading to a lower average equity correlation. A production-based asset-pricing model motivates i) these findings and ii) provides a novel explanation for the market return predictability by average equity correlation. Consistently, I document that the average equity correlation implied by options is influenced by IST shocks and linked to aggregated firm valuations, and hence embeds risks associated with the value premium and growth option dynamics.

Keywords: Option-implied correlation, investment-specific technology shocks, present value of growth options, value premium, factor return predictability, option-implied information JEL: G11, G12, G13, G17

JEL Classification: G11, G12, G13, G17