Measuring investors' risk appetite

Working papers set out research in progress by our staff, with the aim of encouraging comments and debate.
Published on 16 November 2005

Working Paper No. 283
By Prasanna Gai and Nicholas Vause

This paper proposes a new method for measuring investor ‘risk appetite’. Like other indicators in the literature, it is based on a comparison of risk-neutral probabilities of future returns with the corresponding subjective probabilities. The precise nature of the comparison is novel, however, and involves comparing probabilities across the full range of potential returns. Unlike other indicators, our measure of market sentiment distinguishes risk appetite from risk aversion, and is reported in levels rather than changes. Implementation of the approach yields results that respond to crises and other major economic events in a plausible manner.

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