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The CAPM and the risk appetite index; theoretical differences and empirical similarities

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Author Info
Marcello Pericoli () (Bank of Italy, Economic Research Department)
Massimo Sbracia () (Bank of Italy, Economic Research Department)

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Abstract

This paper analyzes the Risk Appetite Index (RAI), a measure of investors’ risk aversion proposed by Kumar and Persaud (2001, 2002). We show that the RAI distinguishes between risk and risk aversion only under theoretically restrictive assumptions on the distribution of returns and the shocks affecting assets’ riskiness. However, by comparing the RAI with a measure of risk aversion derived from the CAPM — a model that does not require those restrictive assumptions — we find that estimates are surprisingly similar. We explain this result by proving that, under a certain condition, the RAI can approximate the risk aversion parameter of a CAPM. This occurs if the ratio between the variance of the returns on assets and the variance of the riskiness of assets is sufficiently small—a condition that is met in our sample.

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Paper provided by Bank of Italy, Economic Research Department in its series Temi di discussione (Economic working papers) with number 586.

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Date of creation: Mar 2006
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Handle: RePEc:bdi:wptemi:td_586_06

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Keywords: CAPM; risk aversion;

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Find related papers by JEL classification:
G11 - Financial Economics - - General Financial Markets - - - Portfolio Choice; Investment Decisions
G12 - Financial Economics - - General Financial Markets - - - Asset Pricing

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Please report citation or reference errors to , or , if you are the registered author of the cited work, log in to your RePEc Author Service profile, click on "citations" and make appropriate adjustments.:
  1. Fama, Eugene F & French, Kenneth R, 1992. " The Cross-Section of Expected Stock Returns," Journal of Finance, American Finance Association, vol. 47(2), pages 427-65, June. [Downloadable!] (restricted)
  2. Breeden, Douglas T., 1979. "An intertemporal asset pricing model with stochastic consumption and investment opportunities," Journal of Financial Economics, Elsevier, vol. 7(3), pages 265-296, September. [Downloadable!] (restricted)
  3. Guiso, Luigi & Parigi, Giuseppe, 1996. "Investment and Demand Uncertainty," CEPR Discussion Papers 1497, C.E.P.R. Discussion Papers. [Downloadable!] (restricted)
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  4. Hartog, Joop & Ferrer-i-Carbonell, Ada & Jonker, Nicole, 2002. "Linking Measured Risk Aversion to Individual Characteristics," Kyklos, Blackwell Publishing, vol. 55(1), pages 3-26.
  5. Miroslav Misina, 2003. "What Does the Risk-Appetite Index Measure?," Working Papers 03-23, Bank of Canada. [Downloadable!]
  6. Friend, Irwin & Blume, Marshall E, 1975. "The Demand for Risky Assets," American Economic Review, American Economic Association, vol. 65(5), pages 900-922, December. [Downloadable!] (restricted)
  7. Avinash Persaud & Manmohan S. Kumar, 2001. "Pure Contagion and Investors Shifting Risk Appetite: Analytical Issues and Empirical Evidence," IMF Working Papers 01/134, International Monetary Fund. [Downloadable!]
  8. Miroslav Misina, 2006. "Benchmark Index of Risk Appetite," Working Papers 06-16, Bank of Canada. [Downloadable!]
  9. Fama, Eugene F & MacBeth, James D, 1973. "Risk, Return, and Equilibrium: Empirical Tests," Journal of Political Economy, University of Chicago Press, vol. 81(3), pages 607-36, May-June. [Downloadable!] (restricted)
  10. Schwert, G. William, 1983. "Size and stock returns, and other empirical regularities," Journal of Financial Economics, Elsevier, vol. 12(1), pages 3-12, June. [Downloadable!] (restricted)
  11. Roll, Richard, 1977. "A critique of the asset pricing theory's tests Part I: On past and potential testability of the theory," Journal of Financial Economics, Elsevier, vol. 4(2), pages 129-176, March. [Downloadable!] (restricted)
  12. Corsetti, Giancarlo & Pericoli, Marcello & Sbracia, Massimo, 2005. "'Some contagion, some interdependence': More pitfalls in tests of financial contagion," Journal of International Money and Finance, Elsevier, vol. 24(8), pages 1177-1199, December. [Downloadable!] (restricted)
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  13. Lucas, Robert E, Jr, 1978. "Asset Prices in an Exchange Economy," Econometrica, Econometric Society, vol. 46(6), pages 1429-45, November. [Downloadable!] (restricted)
  14. Kumar, Manmohan S & Persaud, Avinash, 2002. "Pure Contagion and Investors' Shifting Risk Appetite: Analytical Issues and Empirical Evidence," International Finance, Blackwell Publishing, vol. 5(3), pages 401-36, Winter. [Downloadable!] (restricted)
  15. Stambaugh, Robert F., 1982. "On the exclusion of assets from tests of the two-parameter model : A sensitivity analysis," Journal of Financial Economics, Elsevier, vol. 10(3), pages 237-268, November. [Downloadable!] (restricted)
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Cited by:
(explanations, Please report citation or reference errors to , or , if you are the registered author of the cited work, log in to your RePEc Author Service profile, click on "citations" and make appropriate adjustments.)

  1. Stefano Nobili & Gerardo Palazzo, 2008. "A beta based framework for (lower) bond risk premia," Temi di discussione (Economic working papers) 689, Bank of Italy, Economic Research Department. [Downloadable!]
  2. Gai, Prasanna & Vause, Nicholas, 2005. "Measuring Investors' Risk Appetite," MPRA Paper 818, University Library of Munich, Germany. [Downloadable!]
  3. Prasanna Gai & Nicholas Vause, . "Measuring investors' risk appetite," Bank of England working papers 283, Bank of England. [Downloadable!]
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