Does risk aversion drive financial crises? Testing the predictive power of empirical indicators

Abstract

There are several types of risk aversion indicators used by financial institutions. These indicators, which are estimated in diverse ways, often show differing developments, although it is not possible to directly assess which is the most appropriate. Here, we consider the most well-known of these indicators and construct others with standard methods. As financial crises generally coincide with periods in which risk aversion increases, we try to check if these indicators rise just before the crises and also if they are able to forecast crises. We estimate logit and multilogit models of financial crises -exchange rate and stock market crises -using control variables and each of the risk aversion indicators. In-sample simulations allow us to assess their respective predictive powers. Risk aversion indicators are found to be good leading indicators of stock market crises, but less so for currency crises.

Financial Spillovers to Emerging Markets During the Global Financial Crisis

“…Investors' risk appetite can rapidly change during financial crises when suddenly nonrelated asset markets are impacted by seemingly unrelated financial shocks. Gonzalez-Hermosillo (2008) and Coudert and Gex (2007) are examples of papers that study the importance of risk appetite during crises periods. Finally, theoretical foundations of contagion are studied by Kodres and Pritzker (2002).…”

Time-Inconsistent Portfolio Investment Problems

“…There are many indicators in the market that can, at least partially, measure investors' risk aversion. As mentioned in Coudert and Gex [9], the movement of risk aversion is often correlated with market indices, for example the gold price and VIX. There are also aggregate indicators of risk aversion created by financial institutions such as JP Morgan's Liquidity, Credit and Volatility Index.…”

An eigenvalue approach to risk regimes in currency markets

“…These orthogonal factors are often informative in a financial sense, that is, they lend themselves to meaningful interpretation. 16 For example, Sløk and Kennedy 17 interpret the first two components (derived from stock and bond markets in developed and emerging economies) as a measure of the contribution of industrial production to changes in investor risk aversion. Similarly, McGuire and Schrijvers 18 show that the first PC drives most of the risk premium in 15 emerging markets.…”