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Average Correlation And Stock Market Returns

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Executive Summary

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. Authors show that the average correlation between daily stock returns predicts subsequent quarterly stock market excess returns. They also show that changes in stock market risk holding average correlation constant can be interpreted as changes in the average variance of individual stocks.

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