Abstract
The implied volatility index is a forward-looking indicator of fear among stock market participants. We examine the extent to which the connectedness of fear among global stock markets is driven by the cross-country connectedness of economic policy uncertainty (EPU). We use data on stock market fear and EPU indices for 13 countries, which spans from January 2011 to December 2018. To measure the connectedness among stock market fear and EPU of our sample countries, we employ two connectedness models. A cross-sectional regression model is further employed to ascertain the extent to which EPU connectedness between two countries explains the connectedness of fear between their stock markets, while controlling for bilateral linkage and country-specific factors. We find that EPU connectedness between any two partner countries significantly drives the connectedness of fear between their stock markets. The driving potential not only holds for short- and long-term connectedness, but also after controlling for bilateral linkages (bilateral trade, geographical distance, common language) and country-specific (trade and financial openness of the transmitter country) factors indicating robustness in our results.
Highlights
For international market investors and policymakers, understanding the connectedness of implied volatility is critical to make equity and derivative pricing decisions, as well as to devise hedging and risk management strategies
We find that the stock market fear connectedness across our sample countries is much stronger compared to the economic policy uncertainty (EPU) connectedness between them
EPU connectedness between any two partner countries is a strong driver of fear connectedness between their stock markets
Summary
For international market investors and policymakers, understanding the connectedness of implied volatility (fear) is critical to make equity and derivative pricing decisions, as well as to devise hedging and risk management strategies. As well as improving the understanding of cross-country fear propagation [3,4], this understanding deepens investor’s knowledge on the underpinnings of the market integration phenomenon, which has become increasingly prevalent in the aftermath of the global financial crisis (hereafter GFC). In this vein, the seminal work of Pastor and Veronesi [5] laid out theoretical foundations for the potential effects of economic policy uncertainty (hereafter EPU) on stock returns and volatility. The literature on the driving potential of EPU connectedness for fear connectedness remains scant
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