The Driving Force of Future Real Economic Activity and Stock Market Volatility : Global Risk Aversion

This study examines the effect of global risk aversion on future real economic activity (REA) and stock market volatility. We propose new international real business cycle (RBC) frameworks with a stochastic global risk-aversion spillover process by extending the commonly used RBC models. We also extract relative risk-aversion factors from the S&P 500 and KOSPI 200 options markets, the two most highly liquid options markets in the world, and evaluate global risk aversion’s forecasting ability. Our findings suggest that global risk aversion is a significant driving force in the business cycle of an emerging economy. We show that a foreign country’s risk-aversion factor predicts the emerging market’s future REA at least as well as the domestic risk-aversion factor does. The domestic (Korean) risk-aversion factor predicts domestic stock market volatility over various horizons, whereas the risk-aversion factor from a foreign developed country (the U.S.) predicts stock market volatility over long horizons