Working Paper: CEPR ID: DP12760
Authors: Adrian Buss; Grigory Vilkov; Lorenzo Schnleber
Abstract: 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.
Keywords: expected correlation; implied correlation; correlation risk premium; return predictability; idiosyncratic risk; option-implied information; contemporaneous betas
JEL Codes: G11; G12; G13; G17
Edges that are evidenced by causal inference methods are in orange, and the rest are in light blue.
| Cause | Effect |
|---|---|
| implied correlation (C10) | future market excess returns (G17) |
| comovement of individual stocks (C10) | future market excess returns (G17) |
| implied correlation (C10) | idiosyncratic risk (D81) |
| implied correlation (C10) | dispersion of market betas (C46) |
| expected correlation (C10) | future market excess returns (G17) |
| temporal variations in priced idiosyncratic risk (G19) | predictability of future market excess returns (G17) |
| systematic risk dispersion (G11) | predictability of future market excess returns (G17) |