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What drives investor risk aversion? Daily evidence from the German equity market

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  • Martin Scheicher

Abstract

Stock prices move as corporate earnings prospects change but they also move as investors change their aversion to risk. Aversion to risk gives rise to a risk premium, which consists of an expected extra return that investors require to be compensated for the risk of holding stocks. Option prices are a unique source of information for the estimation of risk premia. The way strike prices in option contracts distinguish between outcomes that are relatively favourable to investors and those that are relatively unfavourable allows an estimate of risk aversion to be extracted from observed option prices. This is done by comparing what is implied in option prices with the probabilities of various outcomes from a purely statistical point of view. The purpose of this special feature is to explain daily movements in the risk aversion of investors in the German stock market as reflected in option prices.2 We focus on the main German index, the Dax, which summarises the stock prices of 30 major German companies. Our data on Dax option prices consist of daily observations from December 1995 to May 2002. To explain movements in our measure of risk aversion, we examine indicators of expectations about economic growth, market volatility, credit risk premia and negative news events. We find that investors in the German equity market seem to have become increasingly risk-averse since 1998. In addition, we note that movements in US stock prices have a strong impact on this risk aversion. We complement the study of Tarashev et al (also in this Quarterly Review) in three respects. First, we analyse risk aversion at a higher frequency: we examine daily movements, while they examine monthly movements. Second, we measure risk aversion in a slightly different way – particularly in estimating statistical probabilities – thus allowing a comparison of two measures and potentially providing a sense of the robustness of option-based measures. Finally, we go a step further by attempting to identify factors that would explain the changes in risk aversion from one day to the next.

Suggested Citation

  • Martin Scheicher, 2003. "What drives investor risk aversion? Daily evidence from the German equity market," BIS Quarterly Review, Bank for International Settlements, June.
    • Handle: RePEc:bis:bisqtr:0306g
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    References listed on IDEAS

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    1. Ait-Sahalia, Yacine & Wang, Yubo & Yared, Francis, 2001. "Do option markets correctly price the probabilities of movement of the underlying asset?," Journal of Econometrics, Elsevier, vol. 102(1), pages 67-110, May.
    2. Rosenberg, Joshua V. & Engle, Robert F., 2002. "Empirical pricing kernels," Journal of Financial Economics, Elsevier, vol. 64(3), pages 341-372, June.
    3. Melick, William R. & Thomas, Charles P., 1997. "Recovering an Asset's Implied PDF from Option Prices: An Application to Crude Oil during the Gulf Crisis," Journal of Financial and Quantitative Analysis, Cambridge University Press, vol. 32(1), pages 91-115, March.
    4. De Santis, Giorgio & Gerard, Bruno, 1997. "International Asset Pricing and Portfolio Diversification with Time-Varying Risk," Journal of Finance, American Finance Association, vol. 52(5), pages 1881-1912, December.
    5. Glatzer, Ernst & Scheicher, Martin, 2003. "Modelling the implied probability of stock market movements," Working Paper Series 212, European Central Bank.
    6. Beber, Alessandro & Brandt, Michael W., 2006. "The effect of macroeconomic news on beliefs and preferences: Evidence from the options market," Journal of Monetary Economics, Elsevier, vol. 53(8), pages 1997-2039, November.
    7. Robert Engle, 2001. "GARCH 101: The Use of ARCH/GARCH Models in Applied Econometrics," Journal of Economic Perspectives, American Economic Association, vol. 15(4), pages 157-168, Fall.
    8. Jackwerth, Jens Carsten, 1999. "Option Implied Risk-Neutral Distributions and Implied Binomial Trees: A Literature Review," MPRA Paper 11634, University Library of Munich, Germany.
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    1. Paun, Cristian & Brasoveanu, Iulian & Musetescu, Radu, 2007. "Absolute Risk Aversion on the Romanian Capital Market," Journal for Economic Forecasting, Institute for Economic Forecasting, vol. 4(4), pages 77-87, December.
    2. Cristian PAUN & Radu MUSETESCU & Iulian BRASOVEANU & Alina DRAGHICI, 2008. "Empirical evidence on risk aversion for individual romanian capital market investors," Review of Economic and Business Studies, Alexandru Ioan Cuza University, Faculty of Economics and Business Administration, vol. 1, pages 91-101, December.
    3. Yasuo Nishiyama, 2006. "The Asian Financial Crisis and Investors’ Risk Aversion," Asia-Pacific Financial Markets, Springer;Japanese Association of Financial Economics and Engineering, vol. 13(3), pages 181-205, September.
    4. Marini, François, 2011. "Financial intermediation in the theory of the risk-free rate," Journal of Banking & Finance, Elsevier, vol. 35(7), pages 1663-1668, July.
    5. Bekaert, Geert & Hoerova, Marie, 2016. "What do asset prices have to say about risk appetite and uncertainty?," Journal of Banking & Finance, Elsevier, vol. 67(C), pages 103-118.
    6. Jose Fique & Frank Page, 2013. "Rollover risk and endogenous network dynamics," Computational Management Science, Springer, vol. 10(2), pages 213-230, June.
    7. Bian, Timothy Yang & Wang, Tianyi & Zhou, Zipeng, 2021. "Measuring investors’ risk aversion in China’s stock market," Finance Research Letters, Elsevier, vol. 42(C).
    8. Coudert, V. & Gex, M., 2006. "Can risk aversion indicators anticipate financial crises?," Financial Stability Review, Banque de France, issue 9, pages 67-87, December.
    9. Prasanna Gai & Nicholas Vause, 2006. "Measuring Investors' Risk Appetite," International Journal of Central Banking, International Journal of Central Banking, vol. 2(1), March.
    10. Coudert, Virginie & Gex, Mathieu, 2008. "Does risk aversion drive financial crises? Testing the predictive power of empirical indicators," Journal of Empirical Finance, Elsevier, vol. 15(2), pages 167-184, March.

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