The Global Determinants of International Equity Risk Premiums

Abstract

We examine the commonality in international equity risk premiums by linking empirical evidence for the international stock return predictability of U.S. downside and upside variance risk premiums (DVP and UVP, respectively) with implications from an international asset pricing framework which features asymmetric macroeconomic and risk aversion shocks. We find that DVP and UVP predict international stock returns through U.S. bad and good macroeconomic uncertainties, respectively. 60% to 80% of the dynamics of the global equity risk premium for horizons under seven months are driven by U.S. economic uncertainty, whereas U.S. risk aversion appears more relevant for longer horizons. The predictability patterns of DVP and UVP vary across countries depending on their financial and economic exposures to global shocks. For those with higher economic exposures, investors demand a higher compensation for bad macroeconomic uncertainty but a lower compensation for good macroeconomic uncertainty, whereas the compensation for bad macroeconomic uncertainty decreases with financial exposure.

Keywords: Downside variance risk premium, Upside variance risk premium, International stock markets, Asymmetric state variables, Stock return predictability

JEL Classification: F36, G12, G13, G15