Fluctuation in investor risk aversion is often cited as a reason explaining crises on financial markets. The undulation between periods of bullishness prompting investors to make risky investments, and phases of bearishness, when they recoil to the safest forms of investments, could be at the origin of sharp fluctuations in asset prices.
There are numerous types of risk aversion indicators exercised by financial institutions (the VIX, the LCVI, the GRAI, etc.). These indices, which are anticipated in diverse ways, often illustrate differing developments, although it is not achievable to directly assess which is the most precise. An interesting approach in this respect is to linkage the indicators to financial crises. In principle, financial crises should correspond with phases in which risk aversion boost. Here the Goldman Sachs risk aversion index is used as explanatory variables which then compared with the financial crises occurred during 1998 to 2003. This allows us to assess their respective predictive powers. The tests carried out show that risk aversion does tend to increase before crises, at least when it is measured by the most relevant indices. This variable is a good leading indicator of stock market crises, but is less so for currency crises.
Chapter No. 1
Introduction
Fluctuation in investor risk aversion is often cited as a reason explaining crises on financial markets. The undulation between periods of bullishness prompting investors to make risky investments, and phases of bearishness, when they recoil to the safest forms of investments, could be at the origin of sharp fluctuations in asset prices.
Risk appetite is one another factor that establishes the demand for risky assets, and this demand can have propositions for the allotment of capital to productive utilization. Outsized changes in risk appetite may possibly also have adverse consequences for financial constancy. Credit booms and improved investment in risky assets ensuing from high investor appetite for risk could eventually lead to a boost in non-performing assets detained by all investors, together with financial institutions.
The risk appetite of financiers may provide evidence to be a vital concept in the study of financial stability. Most macroeconomic and asset-pricing models integrate an assumption about risk appetite. The phenomenon is also often quoted in the media and by public figures as a factor manipulating financial markets. Theory proposes that a low appetite for risk interprets into a higher cost of capital, potentially off-putting business investment, while a high appetite for risk can create booms in credit and asset prices, sowing the seeds of ultimate recessions and pressure on the financial system. The Asian financial crisis of 1997, the after effects of the Russian debt default of 1998, and the failure of high-technology share prices in 2000 are a few examples of events that emerge to be related to complete transformation of investors' appetite for risk.
Not surprisingly, a growing number of financial institutions and organizations in international market have been developing procedures of risk appetite in an effort to measure this phenomenon. These range from the International Monetary Fund's risk appetite index, exercised for market inspection (IMF 2003), to indexes built up by private financial institutions to improve trading returns.
Most of the indexes surveyed treat risk appetite as an arrangement of attitudes and perceptions. Various frameworks are used to review the changes in risk appetite typically indirect by changes in a representative risk premium or by changes in portfolio property. Since price data are more easily available than portfolio data, changes in risk premiums are typically taken to be the primary indicator of changing risk appetite.
Although the indexes surveyed have diverse titles, the concept of risk appetite is understood in their methodology and analysis. These measures are variously referred to as indexes of "risk aversion," "risk appetite," "investor confidence," and "investor sentiment." Generally, they measure risk appetite either by looking at a specific feature of markets (and sometimes a specific market) or by combining information from various markets into a merged measure.
1.1 Types of Risk Aversion Indexes
Illing & Aaron (n.d.) have all asserted to describe risk appetite in equity markets, or in all markets including the equity market. The indexes are classified into two groups: a-theoretic and theory-based.
A-theoretic indexes combined information from various financial markets using statistical methods. These include: the JPMorgan Liquidity, Credit, and Volatility Index (LCVI), the UBSm Investor Sentiment Index (UBS), the Merrill Lynch Financial Stress Index (ML), and the Westpac Risk Appetite Index (WP).
Theory-based indexes originate from economic or financial models and focus on specific markets. These include: the Tarashev, Tsatsaronis, and Karampatos Risk-Appetite Index, developed at the Bank for International Settlements (BIS); the Gai and Vause Risk-Appetite Index, developed at the Bank of England (BE); the Credit Suisse First Boston Risk-Appetite Index (CSFB); the Kumar and Persaud Global Risk-Appetite Index (GRAI), used by both the IMF and JPMorgan; the State Street Investor-Confidence Index (ICI); and the Goldman Sachs Risk-Aversion Index (GS). Finally, the Chicago Board Options Exchange Volatility Index (VIX). The VIX is commonly treated as a rapid and easy alternative for risk appetite, because it is derived from S&P 500 options, which investors buy and sell to alter the amount of risk to which they are exposed. The VIX is also a constituent of all four a-theoretical indexes and is based on the similar underlying data as the BIS and BE indexes.
1.2 Goldman Sachs Risk-Aversion Index (GS)
The GS uses a standard consumption model of capital-asset pricing, where the Arrow-Pratt coefficient of risk aversion is allowed to vary over time. The premise derives from the observation that the "volatility of excess returns from holding stocks over bonds appears to be substantially higher than the volatilities of T-bills and consumption, and only a time-varying risk aversion level can explain such [a] differential" (Goldman Sachs 2003). The GS uses monthly data on real U.S. per-capita consumption, the real rate on 3-month U.S. Treasury bills, and the inflation-adjusted S&P 500 Index. (Illing & Aaron, n.d., para. 28)
1.3 Objective
In this research paper, the predictive power of risk appetite index for financial crises has been measured. Two variables have been taken i-e; Goldman Sachs Risk Appetite Index as dependent variable and time period (financial crises duration) as independent variable. For Analysis descriptive tool has been used in this research.
Chapter No. 2
Literature Review
Holden & Subrahmanyam (1996) argued that the motivation to be short-run oriented in information acquirement decisions is imperative because unnecessary short-term behavior by investors leads to reduced price informative ness about long-run essentials, and intolerant and no worth maximized investment decisions on the part of business managers.
The authors have analyzed the comparative static associated with the stability proportion of agents who gather short-term information. Under a recognized linear equilibrium in the trading period, if the risk repugnance of agents is low, we obtain a central equilibrium in which a certain proportion of agents opts the short-term signal and the opposite proportion chooses the long-term one. However, as the risk aversion parameter is enlarged for all agents, the interior stability disappears and the only remaining stability is one in which all agents collect short-term information. This is for the reason that agents suffer disutility as their positions are buffeted by public information alarm unrelated to their personal information; longer horizons accrue more shocks. Thus, if agents are adequately risk averse, they all select to collect short-term information.
A common perspective of practitioners is that increasing the liquidity of financial markets reduces the cost/benefit ratio for short-term behavior comparatively more than for long-term behavior, and therefore increases the level of "short-termism" in the economy. Short-term investor actions are undesirable because it negatively affects long-term price competence, which is imperative for professional corporate investment decisions.
The authors found that the division of traders who prefer to acquire the short- term signal rises as we raise the variance of information less liquidity trading; this tends to increase market liquidity or depth in equilibrium, but prices replicate more short-term information and less long-term information. These outcomes obtain because a marginal increase in the variance of liquidity trading has a greater optimistic effect on the value of short-term agents than on long-term agents, since short-term investors take more aggressive positions on the basis of the information they have. This tends to encourage collection of the short-term signal, and reduce investor concentration in the long-term one.
Chordia, Sarkar, & Subrahmanyam (2005) found that fund flows and monetary reasons can affect returns and instability in addition to liquidity. There results support the concept that money flows (in the form of bank reserves and mutual fund investments) account for division of the harmony in stock and bond market liquidity.
The authors have précised the results and explained the factor that there are considerable cross-correlations in liquidity improvement after accounting for the outcome of returns and volatility. The impulse reaction results explain evidence that volatility upsets predict liquidity movements in markets.
Raghubir & Ranjan Das (1999) said that "Investors can show various attitudes towards a given intensity of risk: disliking risk (risk averse), being neutral to risk (risk neutral), or loving risk (risk loving). These attitudes are summarized by the Arrow-Pratt coefficient of risk aversion in classical economics".
The authors argued that October 1987 (and it's decennial, October 1997), the Asian market crisis, and the hedge fund crisis of 1998 are all cases in tip. Surprisingly minute agreement could be found, however, about why these events arise. Nevertheless, a consensus emerges to be growing that individual heterogeneity and unconventional behavior play a role in the progress of major financial events.
The researchers argued that theory-driven experimental enquiry has the prospective to provide a distinctive understanding of how people make decision related to their financial investments. Such an understanding should show the way to a forecast of micro level activities and testable hypotheses, some of which may be summative and thus visible in macro level effects. Theory-driven experimental enquiry has the potential to reveal undocumented examples in financial decision making. Researchers may find that a few psychosomatic constructs account for what come out to be a confusing array of anomalies.
Managers can have advantage from understanding the reasons of the many aspects of human psychology that may come into a financial conclusion, some of which direct to no normative behavior. Managers need to be responsive of possible biases in their own and employees activities so employees activities could be controlled by managers, if the biases are of extreme level and difficult to control, report for them in models of risk management.
Managers would also be advised to account in designing and corresponding financial products, for the ways people received and processed financial information and make choices.
Experimental work proposes a valuable complement to experimental methods in understanding financial decisions. They have provided a well-built recommendation for the suitability of incorporating a theory-driven experimental model at the micro level to match existing empirical macro and micro level effort in behavioral finance. They believe that the model offered here is a useful step toward a more widespread theory of how financial assessments are made.
Gron & Winton (2001) showed that an extension of risk from continuing publicity to past transactions can affect existing business decisions, reducing goings-on of the business.
Capital-market imperfections can create otherwise risk-neutral firms perform in a risk- averse fashion and that depressing shocks to internal capital craft firms more risk averse.
When risk obtained through past transactions is costly to diversify, overhang from past transactions raise existing exposure and decreases the additional amount of exposure the firm is prepared to take on in associated business lines. Under some circumstances, the effect can be so vast that no new transactions take place.
The work of Gron & Winton differs as they focused on the effects of risk projection from past business transactions on organizations' decisions and market conditions. As they have showed that by allowing for risk overhang from past business can have a striking effect on equilibrium price and quantity, in some cases leading to total termination of the market.
The idea was that large investors' losses accompanied by an increase in the total risk of losses lead to more adverse selection: first-class firms find it more costly to be insured, so they like to be self- insured, increasing the percentage of bad firms in the insurance pool and ultimately causing the pool to fail.
Increased risk beside with asymmetric information between investors and manufacturers and between manufacturers and consumers causes the market failure.
The risk-overhang theory also presents clear predictions on the relative length of crises.
Masson advances a rationale for risk-averse behavior by investors with little wealth who experience imperfect capital markets.
The researcher offered an analysis which incorporates imperfections in the capital markets with anticipated utility maximization and describes how risk-averse behavior may have great impact on institutional characteristics of the economy, and not necessarily from a psychosomatic aversion to risk. The advantages of this form of analysis are manifest in the policy-oriented hypotheses which it creates.
Bickel (2006) has provided a structure to estimate and leap corporate risk aversion by considering the extent of risk aversion stimulated by the costs of financial distress, costly external finance, and the principal-agent relationship between shareholders and CEOs.
Bickel argued that firms with highly doubtful investment opportunities would reveal greater risk aversion. This paper provides to expand our understanding of corporate risk aversion and facilitates to reconcile the differing techniques taken by the decision analysis and finance societies.
Chambers & Quiggin (2003) presented an analytically simple and well-mannered approach to the study of price constancy for risk-averse firms face stochastic prices and stochastic production situation. They said that indirect certainty equivalent presents an ideal medium by which to check the outcomes of price stabilization. They presented a systematic management of the effects of partial or total mean-preserving price stabilization at the organization level. They said that their work can be applied in future for the analysis of supply reaction, mean-enhancing price stabilization, and for the stabilization of market prices by using buffer stocks.
Weber & Milliman (1997) provided empirical proof that differentiates between substitute conceptualizations of the risky decision making procedure. They investigated whether cross-situational differences in selection behavior should be inferred in the expected utility framework as dissimilarity in risk attitude (as considered by risk-averse vs. risk-seeking utility functions) or as dissimilarity in the view of the relative riskiness of selection alternatives as acceptable by risk-return analysis of utility functions.
Roosen & Hennessy (2003) explained the phenomenon that for risk-averting agents, risks change production decisions while the survival of institutions to assure against difficult states of nature will probably restore decisions toward stages under risk neutrality. They explained the conditions that were identified on a stochastic knowledge to test that risk averters opt smaller input amount than risk neutral agents, and that a high risk aversion reduces input utilization.
Mahul (2000) argued that under the risk of liquidation, the risk-neutral manufacturer shown to reject to carry out a risky project with positive expected surplus return, reveal first-order risk aversion. They said that the most favorable output level of the producer is piecewise linear in assets; whether it decreases or increases depends on whether the expected excess return is optimistic or pessimistic. The producer's perceptible utility function exhibits an S-shaped curve when the preliminary liquid assets are affected by a surroundings risk that is usually distributed.
Chapter No. 3
Methodology
3.1 Variables
The reading of Goldman Sachs Risk Appetite index is taken from 1995-2004. This index is taken as independent variable and after analysis this rating is compared by financial crises occurred during this time duration. The Goldman Sachs Risk Appetite index rating is in terms of percentage. The higher the value, higher the risk appetite and vice versa.
3.2 Statistical Tool
The descriptive statistical tool "Histogram" is applied for analysis of data. The mean of yearly values is calculated and histogram is drawn and then by these 10 years histogram box-plot is drawn.
The data and output sheets are attached in the appendix.
Chapter No.4
Results and Discussion
4.1 Hypothesis
The hypothesis for this research is:
H1: "Fluctuation in risk aversion indicates crises on financial markets."
4.2 Result
Result has support the hypothesis that fluctuation in risk aversion indicates crises on financial markets. The box plot readings have showed that whenever the risk appetite has decreased some financials ups and downs had come. The box plot below showed that risk appetite started declining and as the risk appetite has declined in 1998 the Russian debt default was arise. Then after 1998 Russian debt default, risk appetite started declining in 2000 and then there was a start of bullish market from 2000 to 2003.
The histogram of each year and mean of each year of risk aversion index has also been measured and attached in the appendix.
25% of all values are below the lower quartile Q1.
50% of all values are below (or above) the median.
25% of all values are above the upper quartile Q3.
The box contains 50% of the data (Q3 (75%) - Q1(25%) = 50%).
Between the median and the quartiles are 25% of the data (75% - 50% = 25% and 50% - 25% = 25%), i.e. the position of the median inside the box indicates whether there are more values towards the upper or lower quartile.
The distance of the whiskers is the distribution of the values.
Outliers are those values which are far away from most of the other values.
4.3 Implications
This research will help risk managers to predict financial crises to some extent as the results showed that risk appetite index has the predictive power as whenever it declined in past any financial crises has occurred.
Specifically, this study will provide basis to Pakistan's financial market to build indexes for risk aversion, as there is no such indexes exist in Pakistan and by having these types of indexes for financial markets the corporate and risk managers can help companies to protect from upcoming financial down. This research study is done on the international index as in Pakistan there is no such type of indexes exist.
4.4 Conclusion
The primary goal of this research was to analyze the impact of risk aversion on the financial market crises and as mentioned above the risk aversion indicator has taken for test and analyzed the predictive power of risk aversion indicator for financial crises and the test result has support the hypothesis that fluctuation in risk aversion indicates crises on financial markets. The result shows that whenever risk appetite decreases there are chances of financial crises. This result also shows that the risk aversion or risk appetite indexes has the predictive power of financial crises as the index declined, the financial crises arose.
Similar to other studies, this research also shows that risk aversion has a great impact on financial markets. Masson has argued that risk aversion badly affects the financial decisions. Gron and Winton (Oct., 2001) explained that as the investor starts avoiding risk they immediately begin taking out their investments from risky securities and due to this phenomenon the financial markets crash down as no one wants to take risk and due to this all transactions may cease. The risk averse behavior is usually come to mind whenever there are some rumors passing through the financial market and due to these rumors investors suddenly become risk averse. Bickel (December, 2006) have argued that firms with highly doubtful investment opportunities would reveal greater risk aversion.
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