Changing investors' risk appetite: Reality or fiction?

Abstract

Changes in investors' risk appetite have been used to explain various phenomena in asset markets. And yet, the basis for their use is generally weak: popular indicators of changes in risk appetite typically have scant foundation in theory and give contradictory signals in practice. This has led to the views that it is a convenient ex post rationalization rather than a well-founded explanation of asset price movements. This paper starts from the premise that changing risk appetite might be a legitimate explanation, but that there is an identification problem, both theoretically and empirically. The solution offered here is based on the approach introduced by Kumar and Persaud (Kumar, M., and A. Persaud. 2002. Pure contagion and investors' shifting risk appetite: analytical issues and empirical evidence. International Finance 5: 401–36.), and on the work of Misina (Misina, M. 2003. What Does the Risk-Appetite Index Measure? Bank of Canada, Working Paper 2003–23.) who established the theoretical conditions under which that approach will correctly identify changes in risk appetite. We propose a method to implement these conditions and thus ensure that the resulting index is empirically sound. This index is then used to examine the presence of changes in risk appetite in the data, and, more generally, whether this explanation is appropriate in particular circumstances. The empirical illustration is based on a portfolio of foreign currencies, but the techniques are general and can be applied to any portfolio.