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Paul Ehling and Christian Heyerdahl-Larsen

No 1413, Working Papers from Banco de España

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 returns, 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.

Keywords: equity return correlations; heterogeneous risk aversion; volatility of turnover; cyclical dynamics of stock price moments (search for similar items in EconPapers)
JEL-codes: G10 G11 (search for similar items in EconPapers)
Pages: 91 pages
Date: 2014-06
New Economics Papers: this item is included in nep-rmg
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Citations: View citations in EconPapers (3)

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Journal Article: Correlations (2017) Downloads
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