The Transmissions of Sovereign Risk in Korean Financial Markets

This paper empirically investigated the shock and volatility spillover effects of the CDS, stock, and FX markets inclusive of option markets in Korea over the period 2006-2012. Specifically, we employ a trivariate GARCH model to estimate simultaneously the mean and conditional variance. First, we found the volatility of stock market is more persistent than that of other markets, and there was most significant volatility transmission between stock and FX markets under investigation. Second, CDS market is indirectly more affected by 3M-implied volatility from KOSPI index option market than from FX option market. This study contributes to find that the high liquidity of stock market and relatively loose regulations of FX market in Korea have responded promptly and easily to the dollar demand of European and US financial institutions like automatic transfer machine during the global financial crisis, then the KOSPI index option and sovereign CDS show the bi-directional effects to each other. Therefore, the bi-directional volatility spillover effects between stock and FX markets are a signal of dollar exit, and those between CDS and stock index option markets are a signal of sovereign risk caused by dollar outflow from Korean financial markets.