Series: Working Papers. 1413.
Author: Paul Ehling and Christian Heyerdahl-Larsen.
Published in: Management Science, 63 (2017), pp.1919-1937
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Abstract
Correlations of equity securities have varied substantially over time and remain a source of continuing policy debate. This paper studies stock market correlations in an equilibrium model with heterogeneous risk aversion. In the model, preference heterogeneity causes countercyclical variations in the volatility of aggregate risk aversion. At times of high volatility of aggregate risk aversion, which is a common factor in r turns, we see high correlations. The calibrated model matches average industry return correlations and changes in correlations from business cycle peaks to troughs, and replicates the cyclical dynamics of expected excess returns and standard deviations. A proxy for model-implied aggregate risk aversion jointly explains average industry correlations, expected excess returns, standard deviations and turnover volatility in the data. We find supportive evidence for the model’s prediction that industries with low dividend-consumption correlation have low average return correlation but experience disproportionate increases in return correlations in recessions.