Cross-stock market spillovers through variance risk premiums and equity flows

Summary

Focus

We first calculate the "variance risk premiums" (VRPs) that investors require for taking on stock market volatility risk in major advanced economies (AEs) and emerging market economies (EMEs) over 2007-15. We test whether the US and eurozone AEs' risk premiums affect those of other economies. We also examine the US premium's impact on equity fund flows to other economies.

Contribution

To our knowledge, this is the first paper that uses a parametric model to estimate the VRP in EME stock markets. We decompose the VRP into a part that compensates for the risk of continuous price changes and one that compensates for the risk of discontinuous price changes. We then investigate the cross-market correlations of the three premiums. Moreover, we consider equity fund flows as a possible path through which such premiums spill over globally.

Findings

We find evidence of significant VRP spillovers from the United States and the eurozone AEs to other economies following the Global Financial Crisis of 2007-09. Also, increases in the size of the US premium significantly reduce equity fund flows to all other AEs and some EMEs during the same period.

Abstract

We estimate variance risk premiums (VRPs) in the stock markets of major advanced economies (AEs) and emerging market economies (EMEs) over 2007-15 and decompose the VRP into variance-diffusive risk premium (DRP) and variance-jump risk premium (JRP). Daily VAR analysis reveals significant spillovers from the VRPs of the United States and eurozone's AEs to the VRPs of other economic areas, especially during the post-Global Financial Crisis (GFC) period. We also find that during the post-GFC period, shocks to the DRPs of the United States and the eurozone's AEs have relatively strong and long-lived positive effects on the VRPs of other economic areas whereas shocks to their JRPs have relatively weak and short-lived positive effects. In addition, we show that increases in the size of US VRP, DRP and JRP tend to significantly reduce weekly equity fund flows to all other AEs and some EMEs during the post-GFC period. Finally, US DRP plays a more important role than US JRP in the determination of equity fund flows to all other AEs and some EMEs after the GFC, while the opposite holds true for equity fund flows to all other AEs during the GFC. Such results indicate the possibility of equity fund flows working as a channel of cross-market VRP spillovers.

JEL classification: F32, G12, G15, G23

Keywords: cross-stock market correlation, emerging market economy, equity fund flow, variance risk premium