Dynamic correlation structure and security risk

•Securities that were highly correlated with market-wide risk factors are more likely to have large systematic and idiosyncratic risk in the future.•The relationship between the past correlations of returns and risk is typically found among less transparent securities.•The changing correlation structure of returns is not directly related to the mean returns.

We investigate the relationship between changing correlation structure of returns, security risk, and mean return. According to our results, securities that were highly correlated with the market-wide risk factors in the past are likely to have high systematic and idiosyncratic risk at present. Correlations with the risk factors, however, are not directly related to the mean return of securities, nor can they consistently explain the puzzling relationship between idiosyncratic risk and return. We demonstrate further that the effect of past correlations on security risk is more likely among less transparent securities.