Investors’ Sentiment, Arbitrage Constraints, and KOSPI Market Fear Index

The implied volatility index is the composite index of volatilities of all the options listed on an exchange. The implied volatility index is found to be more sensitive to underlying asset’s price decrease than increase. So it is called ‘fear gauge’ of the stock market. The behavioral finance attributes the existence of asset pricing anomalies to two factors: investors sentiment and arbitrage constraints. This paper attempts to test the effect of investors sentiment and arbitrage constraints on the implied volatility of KOSPI200 (VKOSPI). In order to measure investor sentiment (limits to arbitrage), we constructed the sentiment (arbitrage constraint) index using principal component of ten (nine) sentiment (limits to arbitrage) variables. After controlling the macro economy effects, the new sentiment index and arbitrage constraint index are reestimated. Main results found are as follows: 1) VKOSPI has very significant impacts on KOSPI200 returns. 2) The empirical results are consistent with behavioral explanations. Both investor sentiment and arbitrage constraints derived from the principal component analysis have meaningful effects on VKOSPI. 3) After controlling the macro economy effects, the pure sentiment index has an insignificant effect, but the pure arbitrage constraint index shows significant impacts on VKOSPI variation. 4) The negative effects of pure arbitrage constraints turn out to be more prominent during the period of high VKOSPI. Thus, it confirmed that the cause of market fear is pure arbitrage constraints, rather than pure investor sentiment.