Correlations

Management Science

Finance

Management Science 2017 Vol 63:6 p 1919-1937

Ehling P;Heyerdahl-Larsen C

2017

We study stock market correlations in an equilibrium model with heterogeneous preferences. Heterogeneity in individual risk aversion cause countercyclical variations in the level and the volatility of aggregate risk aversion. When the volatility of aggregate risk aversion increases, which is a common factor in stock returns, then stock return correlations also increase. The calibrated model matches average industry correlations and changes in correlations from business cycle peaks to troughs and replicates the cyclical dynamics of expected excess returns and standard deviations. Model implied aggregate risk aversion explains average industry correlations, expected excess returns, standard deviations and the volatility of turnover, and predicts excess returns in-sample and out-of-sample.

Equity Return Correlations; Heterogeneous Preferences; Quadratic Variation of Portfolios; Cyclical Components of Stock Price Moments

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