Limited Information-Processing Capacity and Asymmetric Stock Correlations

Through an orthogonalized impulse-response analysis, I studied the relationship between the variance risk premium, market variance and stock correlations in the French stock market from September 2002 through September 2006, using high frequency data-based measures. Variance risk premium is estimated using realized variances and index options-implied variances and used as a state vector to proxy investors’ perceived uncertainty. I found that a shock to variance risk premium causes long lasting increases in the market variance pointing to the limitedness of investors’ information-processing capacity. At the same time, the shock generates consecutive increases in realized correlations between individual stocks and the market portfolio. I propose then a possible explanation for the asymmetric/counter-cyclic behavior of stock correlations.