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

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  • Marcello Pericoli

    ()
    (Bank of Italy, Economic Research Department)

  • Massimo Sbracia

    ()
    (Bank of Italy, Economic Research Department)

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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Bibliographic Info

Paper provided by Bank of Italy, Economic Research and International Relations Area 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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References

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  1. Friend, Irwin & Blume, Marshall E, 1975. "The Demand for Risky Assets," American Economic Review, American Economic Association, vol. 65(5), pages 900-922, December.
  2. Robert Stambaugh, . "On the Exclusion of Assets from Tests of the Two-Parameter Model: A Sensitivity Analysis," Rodney L. White Center for Financial Research Working Papers 13-81, Wharton School Rodney L. White Center for Financial Research.
  3. Lucas, Robert E, Jr, 1978. "Asset Prices in an Exchange Economy," Econometrica, Econometric Society, vol. 46(6), pages 1429-45, November.
  4. Kumar, Manmohan S & Persaud, Avinash, 2002. "Pure Contagion and Investors' Shifting Risk Appetite: Analytical Issues and Empirical Evidence," International Finance, Wiley Blackwell, vol. 5(3), pages 401-36, Winter.
  5. Miroslav Misina, 2006. "Benchmark Index of Risk Appetite," Working Papers 06-16, Bank of Canada.
  6. 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.
  7. repec:ebl:ecbull:v:28:y:2003:i:6:p:a6 is not listed on IDEAS
  8. 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.
  9. Miroslav Misina, 2003. "What Does the Risk-Appetite Index Measure?," Working Papers 03-23, Bank of Canada.
  10. Hartog, Joop & Ferrer-i-Carbonell, Ada & Jonker, Nicole, 2002. "Linking Measured Risk Aversion to Individual Characteristics," Kyklos, Wiley Blackwell, vol. 55(1), pages 3-26.
  11. Schwert, G. William, 1983. "Size and stock returns, and other empirical regularities," Journal of Financial Economics, Elsevier, vol. 12(1), pages 3-12, June.
  12. 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.
  13. Manmohan S. Kumar & Avinash Persaud, 2001. "Pure Contagion and Investors Shifting Risk Appetite," IMF Working Papers 01/134, International Monetary Fund.
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Cited by:
  1. Gai, Prasanna & Vause, Nicholas, 2005. "Measuring Investors' Risk Appetite," MPRA Paper 818, University Library of Munich, Germany.
  2. Prasanna Gai & Nicholas Vause, 2005. "Measuring investors' risk appetite," Bank of England working papers 283, Bank of England.

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