Predicting Market Returns Using Covariance Asymmetry Risk Premium

ABSTRACT Implied covariance asymmetry is a market‐wide measure defined as the average of the absolute difference between the downside and upside pairwise co‐movements of individual stocks, estimated from options data. Its risk premium is linked to improved long‐term economic conditions and significantly forecasts excess market returns from 1 month to 2 years. This predictive power persists at horizons beyond 6 months after controlling for popular financial and economic predictors in in‐sample analyses. It also translates into superior out‐of‐sample forecasts and substantial economic gains for a mean‐variance investor, particularly over medium and long horizons.