DP12760 Expected Correlation and Future Market Returns

Author(s): Adrian Buss, Lorenzo Schönleber, Grigory Vilkov
Publication Date: February 2018
Date Revised: December 2018
Keyword(s): contemporaneous betas, correlation risk premium, expected (implied) correlation, Idiosyncratic Risk, option-implied information, return predictability
JEL(s): G11, G12, G13, G17
Programme Areas: Financial Economics
Link to this Page: cepr.org/active/publications/discussion_papers/dp.php?dpno=12760

We document that information about the comovement of individual stocks, jointly extracted from index options and individual stock options, can be used to predict future market excess returns for horizons of up to 1 year, both in-sample and out-of-sample. The predictive power is incremental to that of risk measures exclusively based on the marginal distribution of the market, including (semi)variances and their risk premiums.~We attribute this predictability to the ability of expected correlation to capture expected variations in idiosyncratic risk and in the cross-sectional dispersion in systematic risk. A novel extension of the contemporaneous-beta approach significantly improves out-of-sample predictability.