Expected Stock Returns and the Correlation Risk Premium

In general equilibrium settings with stochastic variance and correlation, the market-return is driven by shocks to consumption, market variance and average correlation between stocks, and hence the equity risk premium is... [ view full abstract ]

In general equilibrium settings with stochastic variance and correlation, the market-return is driven by shocks to consumption, market variance and average correlation between stocks, and hence the equity risk premium is composed of compensations for variance, correlation and consumption risks. A new empirical methodology of market return prediction, such that estimating variance and correlation betas from the joint dynamics of option-implied-variables and index-returns is proposed, resulting in significant out-of-sample R2's of 10,4% (7,0%) for 3 (12)-months forecast horizons. Inline with a risk-based explanation for the existence of a correlation risk premium, we document that expected correlation predicts future diversification risks.