Volatility risk premia and financial connectedness

In this paper we use the Diebold Yilmaz (2009 and 2012) methodology to construct an index of connectedness among five European stock markets: France, Germany, UK, Switzerland and the Netherlands, by using volatility risk premia. The volatility risk premium, which is a proxy of risk aversion, is measured by the difference between the implied volatility and expected realized volatility of the stock market for next month. While Diebold and Yilmaz focus is on the forecast error variance decomposition of stock returns or range based volatilities employing a stationary VAR in levels, we account for the (locally) long memory stationary properties of the levels of volatility risk premia series. Therefore, we estimate and invert a Fractionally Integrated VAR model to compute the cross forecast error variance shares necessary to obtain the index of total connectedness and the net contribution of each series to total connectedness. The results show that, over January 2000-August 2013, the index of total connectedness among volatility risk premia has been relatively stable with an increasing role played by France and with a positive (but decreasing) role played by Germany and the Netherlands. Non EMU countries such as the UK and Switzerland are negative net contributors to the index.