Global investors’ shifting risk appetite: What have equity and

bond prices to say?

Marcelo Fernandes
Queen Mary, University of London
E-mail: m.fernandes@qmul.ac.uk

Samy Yoshima
Vision Brazil Investments
E-mail: syoshima@visionbrazil.com

Abstract: We propose a consistent estimator for the investors’ risk appetite that depends exclu-
sively on asset returns data. In particular, our estimator also has a nonparametric flavor in that
it makes no parametric assumption on preferences and on the stochastic process that governs the
dynamics of asset returns. This is in stark contrast with the extant estimators in the literature that
usually require options data and assume that asset returns follow a geometric Brownian motion.

JEL classification numbers: G12, C13, C23, E44

Keywords: asset pricing, fixed-effects panel regression, incomplete markets, market sentiment,
minimum-variance stochastic discount factor, risk appetite, risk tolerance.

1
1 Introduction

Investors’ shifting risk appetite may engender a pure form of contagion that does not remotely
relate to economic fundamentals. Due to the increasing interest in the role it plays in the financial
markets, the literature offers a number of indicators to gauge changes in the investors’ risk appetite.
Any risk-appetite measure must not exclusively depends on the level of uncertainty in the economy
given that its fluctuation over time does not necessarily involve changes in the risk appetite.
There is an increasing interest in measuring investors’ risk appetite. The exact definition of
risk appetite though is a bit controversial (see Kumar and Persaud, 2002; Gai and Vause, 2006).
Most authors nevertheless agree that it relates to some sort of market sentiment reflecting the
willingness of investors to bear risk. This means that any measure of risk appetite must involve
not only investors’ attitude towards risk, but also the level of risk.
Risk appetite, by contrast, is likely to shift periodically as investors respond to episodes of
financial distress and macroeconomic uncertainty. In adverse circumstances, investors will require
higher excess expected returns to hold each unit of risk and risk appetite will be lowit is the inverse
of the price of risk. And when the price of risk is taken together with the quantity of risk inherent
in a particular asset, the expected return required to compensate investors for holding that asset
is the risk premium. Figure 1 illustrates these concepts. It is clearly difficult to disentangle risk
appetite from risk aversion in that an increase in either one of them causes asset prices to decline
and risk premia to increase.
In what follows, we formally distinguish risk appetite from risk premia and aversion. Specifically,
we propose a measure based on the variation in the ratio of risk-neutral to subjective probabilities
used by investors in evaluating the expected payoff of an asset. By exploiting the linkages between
the risk-neutral and subjective probabilities that can be extracted from financial market prices,
we follow Hayes, Panigirtzoglou and Shin (2003), Tarashev, Tsatsaronis and Karampatos (2003),
and Bollerslev, Gibson and Zhou (2004). Unlike these papers, however, we are able to extract an
indicator of market sentiment that is quite distinct from risk aversion.
This paper proposes a consistent estimator for investors’ risk appetite that relies exclusively on
asset returns data, without making any parametric assumption on preferences and on the stochastic
process that governs the dynamics of asset prices. In particular, we focus on a panel-regression
framework to derive an estimator for the demeaned realizations of the minimum-variance stochastic
discount factor (MVSDF) and then extract the market price of risk by computing the variance of
the MVSDF using a realized approach. The latter is convenient because it permits investors’ risk

2
appetite to shift over time. The precision of our risk-appetite estimator ameliorates as both the
number of time series observations and the number of assets in the economy increase. This is in
stark contrast with any option-implied risk-appetite index, whose performance does not necessarily
improve with the number of assets. Actually, the common practice is to employ option data on
only one underlying asset.
Our results give structure to the intuitive notion that investors’ risk appetite responds to eco-
nomic state variables, and should be of direct interest to market participants and monetary policy-
makers alike who study the links between the financial markets and the overall economy. Interest-
ingly, we also find that the estimated time-varying volatility risk premium index helps to predict
future stock market returns better than other well-established predictor variables, including the
consumption-wealth ratio (CAY) of Lettau and Ludvigson (2001).
The remainder of this paper ensues as follows. Section 2 describes the theoretical foundation
for the risk-appetite index that rests on the MVSDF approach to asset pricing. Section 3 discusses
our two-step estimation procedure. The first step estimates the MVSDF using exclusively asset
prices data, whereas the second step consists of computing the risk-appetite index by estimating
the MVSDF-implied market price of risk. Section 4 then documents the evolution of the global
investors’ risk appetite since 1990 in light of some historical events. Section 5 offers some concluding
remarks.

2 Risk appetite and the stochastic discount factor

The uncertainty in the economy ultimately relates to the variation of consumption among the
different states of nature, and hence it is natural to derive an investors’ risk appetite index that
depends on the stochastic discount factor (SDF) in view that the latter relates to the growth
rate of the marginal utility of consumption. As in Hansen and Jagannathan (1991), we assume a
frictionless economy in which the law of one price holds, so that
 
Et Mt+1 Ri,t+1 = 1, i ∈ {0, . . . , N } (1)

where Et (·) denotes the conditional expectation given the available information at time t, Mt is
the stochastic discount factor, R0,t denotes the gross return on the risk-free asset, Ri,t denotes the
gross return on the ith risky asset, and N is the number of risky assets in economy. In the CCAPM
context, the pricing equation (1) mainly illustrates the fact that consumers equate marginal rates
of substitution to prices in view that the SDF coincides with the intertemporal marginal rate of
substitution.

3
 The existence of a stochastic discount factor Mt that prices assets according to (1) only requires
the law of one price. It is not necessary to assume, for instance, that there is a complete set of
security markets. It is only to ensure the uniqueness of the SDF that one must assume away
incomplete markets. Under market incompleteness, there exists an infinite number of stochastic
discount factors that correctly price all traded securities. Notwithstanding, there still exists a
unique discount factor that lies on the payoff space, namely, the minimum-variance stochastic
discount factor (MVSDF). The latter coincides with the projection of any SDF onto the payoff
space, and hence they share the same pricing implications (see Cochrane, 2001).
We will also implicitly assume that the MVSDF is positive given that our estimation strategy
employs a log transformation. This assumption implies that there are no arbitrage opportunities
in the payoff space. It is a quite mild assumption, though somewhat stronger than the general
no arbitrage condition, which only guarantees that there exists at least one positive discount fac-
tor. Despite the fact that it requires local non-satiability, we impose no other restriction on the
preferences representation.
Section 2.1 follows Gai and Vause (2006) in defining the risk appetite index as the inverse of the
market price of risk, though the estimation strategy that we derive in Section 3 differs substantially
from theirs. In particular, we retrieve the market price of risk by modeling the ex-post realization
of the MVSDF integrated variance. Our estimation strategy relies on a two-step procedure. In
the first step, we estimate the MVSDF using Araujo, Issler and Fernandes’s (2006) nonparametric
approach so as to avoid parametric assumptions on preferences representation and on the stochastic
process that governs asset prices’ dynamics. In the second step, we infer the MVSDF integrated
variance using model-free realized measures and so we must impose a semiparametric stochastic
volatility model for assets’ log-price.
Under mild assumptions on preferences, log-price processes in any frictionless arbitrage-free
market must obey a semimartingale process (Back, 1991). We thus assume, as in Bollerslev et al.
(2004), that the log-price process follows a general continuous-time stochastic volatility model, viz.
dpi,t =
 µi,t (·) dt
 + σi,t dBi,t
2 2 (2)
dσi,t = αi δi − σi,t dt + ςi,t (·) dWi,t

where the instantaneous correlation between the two Brownian motions dBi,t and dWi,t is constant,
corresponding to the familiar leverage effect, and the functions µi,t (·) and ςi,t (·) satisfy the usual
no arbitrage and regularity conditions. The semiparametric specification given by (2) is flexible
enough to model most asset returns, though it is also possible to extend our framework to deal
with jump-diffusion processes (see Andersen, Bollerslev and Diebold, 2005).

4
2.1 Risk-appetite index

The pricing equation (1) states that, once we discount any gross return by Mt , every security entails
zero excess return over the risk-free asset. It applies to every asset in the economy, even for the
risk-free asset. To appreciate that, one may rewrite (1) as

Et (Mt+1 ) Et (Ri,t+1 ) + covt (Mt+1 , Ri,t+1 ) = 1, (3)

where covt (·) denotes the conditional covariance given the available information at time t. The first
term relates to the risk-neutral component in that it illustrates the expected return that investors
would require to hold that asset if they were risk neutral. In turn, the covariance term corresponds
to a risk adjustment that compensates risk-averse investors to hold that risky asset.
As the risk-free rate of return is measurable on the information set available at time t, it ensues
that R0,t+1 = 1/Et (Mt+1 ) and hence

Et (Ri,t+1 − R0,t+1 ) = −R0,t+1 covt (Mt+1 , Ri,t+1 ). (4)

This means that investors require a premium to hold assets whose payoffs are higher in periods
of high (rather than low) consumption. The usual beta-decomposition of the risk premium in (4)
then yields
covt (Mt+1 , Ri,t+1 )
Et (Ri,t+1 − R0,t+1 ) = − × σt2 (Mt+1 ) R0,t+1 , (5)
σt2 (Mt+1 ) | {z }
| {z } λt
βi,t

where σt2 (·) denotes the conditional variance given the available information at time t. The beta
term corresponds to the amount of risk, whereas the market price of risk λt is the expected excess
return that investors require in order to hold an additional unit of risk in equilibrium.
As in Gai and Vause (2006), we define risk appetite as the inverse of the market price of risk.
This ensures that the risk premium is decreasing with the investors’ risk appetite. This is in line,
for instance, with the view that emerging markets sovereign bonds must pay a higher risk premia
when investors are less willing to bear risk (Baek, Bandopadhyaya and Du, 2005). As is apparent
from the beta-decomposition in (5), Gai and Vause’s risk appetite measure mainly depends on the
variation in the stochastic discount factor. In view that the latter specifies the marginal rate at
which the investor is willing to substitute uncertain future consumption for present consumption,
risk appetite is a function not only of the investors’ risk aversion, but also of the overall level of
uncertainty surrounding consumption prospects. The latter dependence explains why risk appetite
may vary significantly over time, even though risk aversion is likely to remain constant.

5
 Section 3 departures from Gai and Vause’s (2006) framework in that we estimate the risk-
appetite index in a completely different manner. Gai and Vause exploit the fact that the SDF
relates to the ratio of the risk-neutral to subjective probabilities to estimate the market price of
risk using options data (see also Hayes et al., 2003; Tarashev et al., 2003; Bollerslev et al., 2004).
In contrast, we rely exclusively on asset prices data, employing the nonparametric approach put
forth by Araujo et al. (2006).

3 Estimation strategy

To conduct statistical inference, we must impose some restrictions on the stochastic nature of asset
returns and of the stochastic discount factor. For the sake of exposition, we start with the unre-
alistic assumption of conditional lognormality and homoskedasticity, even though the results still
hold in a much more general setting (see Araujo et al., 2006). It is also worth noting that condi-
tional lognormality and homoskedasticity has a long pedigree in macroeconomics (e.g., Hansen and
Singleton, 1983; Campbell, 1993; Lettau and Ludvigson, 2001), whereas conditional lognormality is
standard in financial econometrics, especially in the context of conditional heteroskedasticity (e.g.,
Bollerslev et al., 2004; Meddahi and Renault, 2004).
Taking logs of both sides of the pricing equation (1) gives way to

ln Et (Mt+1 Ri,t+1 ) = 0, i ∈ {1, . . . , N }. (6)

Conditional lognormality then implies that, for every i ∈ {1, . . . , N },

Et (mt+1 + ri,t+1 ) + 1
2 σt2 (mt+1 + ri,t+1 ) = 0, (7)

where mt = ln Mt , ri,t = ln Ri,t , and the conditional variance σt2 (·) given the available information
at time t is constant, say σi2 , under the conditional homoskedasticity assumption. Decomposing
ri,t+1 + mt+1 into the projection on the information set at time t and an orthogonal error results in

ri,t+1 + mt+1 = Et (ri,t+1 + mt+1 ) + i,t+1 , (8)

where i,t+1 is Gaussian with mean zero and variance σi2 given the conditional lognormality and
homoskedasticity assumptions.
From (7) and (8), it follows that

ri,t+1 = − mt+1 − 1
2 σi2 + i,t+1 . (9)

In the context of panel-data regression, (9) corresponds to a standard unobserved fixed-effects model
with no explanatory variables other than time dummies, also known as the two-way fixed-effects

6
model (see Baltagi, 2001). Stacking the estimates of the coefficients of the time dummies then
presumably provide a consistent estimate for the series of the log-SDF, whereas the fixed-effects
capture the individual heterogeneity stemming from the second moment of the log-returns. It turns
out however that (9) identifies the coefficients of the time dummies only up to a normalization
constant, though Araujo et al. (2006) show how to consistently recover the level of the MVSDF at
times t = 2, . . . , T . Under some additional conditions, they show that

T
!−1
R̄tG X R̄s
M
ct = , (10)
T −1 R̄sG
s=2

where R̄t and R̄tG are respectively the cross-sectional arithmetic and geometric average of assets’
gross returns, converges in probability to the realization of the MVSDF as both the time-series and
cross-section sample sizes grow without bound.
We deem that our estimator has some interesting properties. First, the estimation procedure
is straightforward in that it relies on a standard two-way fixed-effects regression. In fact, the
resulting estimator is also very simple given that it depends only on averages of the asset log-
returns. Second, it postulates neither a particular preference representation nor any pricing theory.
Third, our estimator is consistent with the risk-premium for it avoids the excessive smoothness of
consumption data.

3.1 Estimating the market price of risk

The estimation procedure of the risk-appetite index consists of two steps. The first estimates
the minimum-variance stochastic discount factors by (10), whereas the second step consists of
estimating the market price of risk by computing the MVSDF realized variance. In particular, the
risk-appetite estimator displays a semiparametric character in that it assumes that asset returns
follow a semiparametric stochastic volatility model without imposing any parametric assumption
on preferences.
To estimate the market price of risk, we must compute the conditional variance of the MVSDF.
Accordingly, we first estimate the ex-post realization of the MVSDF integrated variance and then
condition on the past information set as in Bollerslev et al. (2004).

3.2 Discussion

Persaud (1996), Kumar and Persaud (2002), Baek et al. (2005), Bandopadhyaya and Jones (2006),
and Dupuy (2005) attempt to identify changes in risk appetite by looking at the rank correlation
between assets’ riskiness and excess returns. The idea lies on the fact that such a rank correlation

7
is presumably higher in periods of shifting risk appetite than in relatively stable periods. Although
it is simple and quite intuitive, this approach reveals several drawbacks (see discussion in Gai and
Vause, 2006). The main disadvantage refers to the fact that the rank correlation indeed identifies
changes in risk appetite only under the very strong assumption of linear independence of assets
returns (Misina, 2003).
Froot and O’Connell (2003) propose to gauge investors’ confidence by examining institutional
investors’ portfolio holdings and investment flows. They assume that changes in portfolio holdings
are a function of expected returns, risk, wealth, and risk tolerance. Their empirical results indicate
that the risk-tolerance component explains most of the variation in the institutional investors’
portfolio holdings. Froot and O’Connell’s (2003) approach has two serious drawbacks, however.
First, it does not provide a genuine measure of risk appetite, though risk tolerance certainly relates
to the investors’ willingness to bear risk. Second, it heavily depends on the assumption that changes
in risk tolerance affect holdings in an equiproportional manner, which boils down to imposing a
preferences representation with either constant absolute or relative risk aversion.
Tarashev et al. (2003) offer a more interesting alternative to estimate a risk-appetite index.
They show that one may gauge investors’ risk appetite by computing the level of the stochastic
discount factor in different states of nature. Because this corresponds to computing ratio of the
quantiles of the risk-neutral and subjective distributions of asset returns, Tarashev et al. propose
a framework that relies on the estimation of the risk-neutral distribution using options data. Their
identification and estimation strategy exhibits three drawbacks. First, they are not able to properly
control for the error-in-variable issue that arises in the first-step estimation of the risk-neutral
and subjective distributions. Second, the estimation of the risk-neutral distribution requires some
restrictive assumptions on the dynamic behavior of the underling asset prices. Third, estimating
the ratio at a particular quantile may misrepresent investors’ overall attitude towards risk.
Gai and Vause (2006) define a risk-appetite index as the inverse of the market price of risk,
i.e., the expected excess return that investors require, in equilibrium, to hold one additional unit of
risk. Even though their definition clarifies that the risk-appetite index depends on the risk-neutral
distribution only through the variance of the stochastic discount factor, Gai and Vause estimate
the market price of risk by computing the variance of the ratio of the risk-neutral and subjective
probability distributions. This solves the third drawback of Tarashev et al.’s (2003) methodology,
but not the first two.
Bollerslev et al. (2004) develop a similar methodology that focus on the differences between

8
the volatilities of the risk-neutral and subjective distributions so as to identify a volatility risk
premium. They attempt to robustify the estimation procedure by using model-free measures of
integrated volatility. In particular, they estimate the options-implied volatility using Britten-Jones
and Neuberger’s (2000) model-free estimator and the volatility of the subjective distribution using
a realized approach (Barndorff-Nielsen and Shephard, 2002; Meddahi, 2002; Andersen, Bollerslev,
Diebold and Labys, 2003; Barndorff-Nielsen and Shephard, 2004). Bollerslev et al. then estimate by
GMM the volatility risk premium using conditional cross-moments of the risk-neutral and subjective
expectations of the integrated volatility. Although their GMM framework solves the error-in-
variable issue in an efficient manner, it still provides an incomplete picture of investors’ risk appetite
in view of their emphasis on the risk-neutral and subjective volatilities.

4 Global investors’ risk appetite

5 Conclusion

This paper proposes a novel measure of market risk appetite that relies on robust estimates of
the market price of risk. Our estimator has a nonparametric flavor in that it makes no parametric
assumption on preferences and on the stochastic process that governs the dynamics of asset returns.
This is in contrast with the existing estimators in the literature that assume that asset returns follow
a geometric Brownian motion. In addition, our estimator improves as the number of assets in the
economy increases.

9
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