Expected Stock Returns and the Correlation Risk Premium

We develop and test a new methodology for out-of-sample forecasts of the market excess return, based on the variance and correlation risk premium. Estimating contemporaneous variance and correlation betas from the joint dynamics of option implied variables and index returns, we find significant out-of-sample R2's of 10% and 8% for 3- and 12-months forecast horizons, respectively. While the predictability of the variance risk premium is strongest at the intermediate, quarterly horizon, the correlation risk premium dominates at longer horizons. In line with a risk based explanation for the existence of a correlation risk premium, we document that expected correlation predicts future diversification risks.