Correlations

Abstract

Correlations of equity returns 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 variations in the volatility of aggregate risk aversion from good to bad states. At times of high volatility in aggregate risk aversion, which is a common factor in returns, we see high correlations. The model matches average industry return correlations and changes in correlations from business cycle peaks to troughs and replicates the dynamics of expected excess returns and standard deviations. Model-implied aggregate risk aversion 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 disproportional increases in return correlations in recessions. This paper was accepted by Jerome Detemple, finance.