Average correlation and stock market returns

Joshua M. Pollet, Mungo Wilson

Research output: Contribution to journalArticlepeer-review

Abstract

If the Roll critique is important, changes in the variance of the stock market may be only weakly related to changes in aggregate risk and subsequent stock market excess returns. However, since individual stock returns share a common sensitivity to true market return shocks, higher aggregate risk can be revealed by higher correlation between stocks. In addition, a change in stock market variance that leaves aggregate risk unchanged can have a zero or even negative effect on the stock market risk premium. We show that the average correlation between daily stock returns predicts subsequent quarterly stock market excess returns. We also show that changes in stock market risk holding average correlation constant can be interpreted as changes in the average variance of individual stocks. Such changes have a negative relation with future stock market excess returns.

Original languageEnglish (US)
Pages (from-to)364-380
Number of pages17
JournalJournal of Financial Economics
Volume96
Issue number3
DOIs
StatePublished - Jun 1 2010
Externally publishedYes

Keywords

  • Correlation
  • Roll critique

ASJC Scopus subject areas

  • Accounting
  • Finance
  • Economics and Econometrics
  • Strategy and Management

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