Variance risk premium in a small open economy with volatile capital flows: The case of Korea

Abstract

This paper extends the research on the variance risk premium by considering a small open economy with volatile capital flows—the Korean economy. The empirical analysis in this paper finds that as in the US, the variance risk premium in Korea has a predictive power for the Korea Composite Stock Price Index (KOSPI) 200 stock returns over one-month and three-month horizons, indicating that it reflects the level of risk aversion in the Korean economy. The short-term forecasting ability of the variance risk premium is comparable to that of other popular predictor variables, such as the dividend yield and output gap. Moreover, a factor-augmented vector autoregression (FAVAR) analysis shows that the global liquidity sector is more important than the domestic macroeconomic sector in determining the variance risk premium. An increase in global liquidity significantly reduces both the variance risk premium and economic uncertainty.