Monetary Policy, Risk Aversion and Uncertainty in an International Context

This paper analyses the interaction of monetary policy (both domestic and global), risk aversion and uncertainty for a set of advanced and emerging economies in vector autoregressive (VAR) framework. Variance risk premium (VRP) is used as a measure of risk aversion and computed as the difference between the risk-neutral and the physical expectation of the return variance. VRP is positive on average for all economies and exhibits significant inter-temporal variation. Results reveal that expansionary monetary policy leads to a short-term increase in risk aversion and a decrease in uncertainty. Central banks respond by reducing the policy rate in response to risk aversion and uncertainty shocks. Both risk aversion and uncertainty exhibit a higher magnitude of response to domestic as compared to the global monetary policy shocks. Further, we find that risk aversion positively affects risk premium and thus, considerably explains variations in excess returns in the market.