Research seminars

Expected Stock Returns and the Correlation Risk Premium

Finance

Speaker: Grigory Vilkov
Frankfurt School of Finance & Management

14 September 2017 - T017 - From 2:00 pm to 3:15 pm

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In a general equilibrium model with stochastic variance and correlation, we decompose the equity risk premium into compensations for variance, correlation and consumption risks. Based on this decomposition, we develop and test a new methodology for out-of-sample forecasts of the market excess return. Estimating contemporaneous variance and correlation betas from the joint dynamics of option-implied variables and index returns, we find significant out-of-sample R2’s of 10.4% and 7.0% for 3- and 12-months forecast horizons, respectively. While the predictability
of the variance risk premium is strongest at the intermediate (quarterly) horizon, the correlation risk premium dominates at longer horizons. In line with a risk-based explanation for the existence of a correlation risk premium, we document that expected correlation predicts future diversification risks.

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