Covariance Risk Premium and Expected Stock Returns

Abstract

The covariance risk premium (CRP), defined as the difference between the expected physical covariance and the risk-neutral covariance of implied volatility changes and market index returns, is positively and significantly related to future stock market returns across horizons ranging from 1 month to 24 months. This paper empirically demonstrates that the CRP exhibits significant in-sample and out-of-sample predictive ability. It generates substantial economic value for a mean-variance investor and outperforms many well-known predictors. Furthermore, covariance risk is driven by credit risk and is related to market volatility and skewness through a decomposition.

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