Bond risk premia in a small open economy with volatile capital flows: The case of Korea

This paper investigates bond risk premia embedded in Korean government bonds. Unlike the U.S., Korea is a small open economy characterized by highly volatile capital flows and non-reserve currency country. My empirical findings show that among alternative predictive variables (including the macro and global liquidity factors) for one-year-ahead excess bond returns, the global liquidity factors, extracted from the panel data set of various global liquidity variables, are the only predictors that perform well across both in- and out-of-sample forecast analysis. In a similar vein, the regression analysis for the determinants of the estimated bond risk premia (with both monthly and quarterly frequencies) reveals that similar to the case of U.S. bond market, the risk premia in Korean government bonds are affected by domestic expected inflation, but more importantly, that they are affected heavily by the global liquidity variables, such as VIX, bank capital flows and the leverage of global banks.