Correlations

85 Pages Posted: 5 Mar 2007 Last revised: 16 Aug 2013

See all articles by Paul Ehling

Paul Ehling

BI - Norwegian Business School

Christian Heyerdahl-Larsen

Indiana University - Kelley School of Business - Department of Finance

Multiple version iconThere are 2 versions of this paper

Date Written: August 2013

Abstract

Correlations of equity securities have varied substantially over time and remain a source of continuing policy debate. This paper studies stock market correlations in an equilibrium model with heterogeneous risk aversion. In the model, preference heterogeneity causes countercyclical variations in the volatility of aggregate risk aversion. At times of high volatility of aggregate risk aversion, which is a common factor in returns, we see high correlations. The calibrated model matches average industry return correlations and changes in correlations from business cycle peaks to troughs and replicates the cyclical dynamics of expected excess returns and standard deviations. A proxy for model implied aggregate risk aversion jointly explains average industry correlations, expected excess returns, standard deviations and turnover volatility in the data. We find supportive evidence for the model's prediction that industries with low dividend-consumption correlation have low average return correlation but experience disproportional increases in return correlations in recessions.

Keywords: Equity Return Correlations, Heterogeneous Risk Aversion, Volatility of Turnover, Cyclical Dynamics of Stock Price Moments

JEL Classification: G10, G11

Suggested Citation

Ehling, Paul and Heyerdahl-Larsen, Christian, Correlations (August 2013). AFA 2011 Denver Meetings Paper. Available at SSRN: https://ssrn.com/abstract=968250 or http://dx.doi.org/10.2139/ssrn.968250

Paul Ehling (Contact Author)

BI - Norwegian Business School ( email )

N-0442 Oslo
Norway
+47 46410505 (Phone)

Christian Heyerdahl-Larsen

Indiana University - Kelley School of Business - Department of Finance ( email )

1309 E. 10th St.
Bloomington, IN 47405
United States

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