3.3 VALUATION
3.3.4 Risk appetite
The corporate bond market is a leading indicator of economic activity.
However, its forecasting power is obviously not perfect, because – like equity markets – credit spreads sometimes predict recessions that do not occur subsequently. After the 1987 stock market crash, for example, credit spreads widened significantly. A similar observation could be made in 1998, following the LTCM hedge fund crisis and Russia’s default. Yet, both events were not followed by a recession. The spread widening rather mirrored increasing risk averseness of investors. In general, risk appetite or risk aversion refer to market participants’ willingness and ability to invest in risky assets.
Market participants often cite changes in investors’ risk appetite as a possible explanation for developments in global financial markets that cannot be explained by changes of market fundamentals. Indeed, financial crises often seem to coincide with abrupt shifts in market sentiment from risk tolerance to risk avoidance. While fundamentals undoubtedly remain of significant importance, these shifts are likely to reflect the effective risk attitude as manifested through the behavior of active investors. But behav- ior similar to that induced by shifts in the fundamental preferences of investors over risk and return can also reflect changes in the composition of active market players or tactical trading patterns. Theoreticians like Kumar
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and Persaud (2001) argue that investors’ risk appetite not only changes over time, but also that these changes can be measured. If included in fundamen- tally based econometric models, risk appetite can lead to more accurate forecasts of market developments. Tools that track the dynamics of investors’ willingness to take on risks can lead to a better understanding of the functioning of financial markets. In particular, they can supplement the risk management of institutional investors. Sophisticated models therefore aim to distill a measure for risk appetite from a broad spectrum of suffi- ciently liquid assets. By taking various assets from across the global risk spectrum, a comprehensive comparison of the returns that they have offered relative to risk can be made.
Geopolitical risks like war and terror can create stress scenarios for all risky asset classes. The geopolitical situation has a strong impact on the risk aversion of investors. The events of September 11, 2001, provide a tragic example after which investors bought safe haven assets such as govern- ment bonds and gold at the cost of risky asset classes. Very risky and illiq- uid asset classes are particularly sensitive to changes in risk appetite. In times of growing risk appetite, more volatile and hence riskier assets per- form well as investors become more willing to tolerate risk in exchange for higher expected returns. When risk appetite is falling, the reverse happens as risk premia rise and funds flow to safer assets. Consequently, special attention has to be paid in periods of high uncertainty. The most important indicators for risk aversion should be observed regularly. Among the most common indicators are implied volatilities and put/call ratios on equity options and options on interest rate future. The relative performance of growth and value stocks or high and low beta stocks can also help to esti- mate risk appetite. Gold and oil prices, too, often react quickly to changes in the geopolitical environment. Intermarket comparisons of the performance and volatility of different asset classes not only indicate changes in the risk- loving attitude of investors, but also contain valuable information about the relative attractivity of certain markets. However, some of the above- mentioned indicators may temporarily be distorted through demand and supply dynamics, or through a lack of liquidity.
The cyclical nature of risk appetite is shown in Figure 3.29. Changes in risk appetite seem to depend on the level of risk appetite in the preceding month. Up- and downswings of risk appetite are driven by investors’ per- ceptions. If risky assets have outperformed for some time, investors tend to expect a continuation of this outperformance. Conversely, during times of underperformance of risky assets, investors apparently recall the downside risks associated with higher yielding assets. At the height of the equity bub- ble in March 2000, for example, riskier assets had been performing better than safer assets, whereas at the ‘panic’ low in October 2002, riskier assets had been performing worse. It should be noted that reversals seem to become more and more likely as risk appetite reaches extreme levels. For
example, having made a panic low CSFB’s Global Risk Appetite Index usually reenters the euphoria zone in roughly 12–18 months. This index is calculated as the slope of a weighted regression of the returns of a broad range of assets from across the global risk spectrum against their historical return volatility. At a ‘euphoric’ peak as in March 2000, riskier assets had been performing a lot better than safer assets, whereas at a ‘panic’ low such as October 2002, riskier assets had been performing worse. Kindleberger (1978) describes the periods when the risk appetite reaches extremes as
‘distress’. He notes that in the extreme zone there appears to be an increased probability that events, which normally would be ignored by financial markets, trigger a reversal of the cycle.
Tversky and Kahneman (1974, 1979) and Shiller (1998) argue that the assumption of rational, utility-maximizing behavior of investors is fre- quently violated in real life. They also show that these anomalies can be predicted and that they result from the use of simple heuristics to facilitate the process of decision-making. Sophisticated investors can benefit from this fact if they are able to predict changes in the direction of risk appetite correctly. In particular, reversals in risk appetite often correspond with turning points in the direction of spreads. Risk appetite indicators may also be a useful tool for major asset allocation decisions such as stocks versus
Figure 3.29 Baa corporate bond spreads and CSFB Global Risk Appetite Index
Source: CSFB and Moody’s –6
–4 –2 0 2 4 6 8 10
1981 1983 1985 1987 1989 1991 1993 1995 1997 1999 2001 2003 0 50 100 150 200 250 300 350 400 450 Panic
Spread (bp)
Euphoria
CSFB Global Risk Appetite Index
Moody's Baa corporate spread versus treasuries
bonds, value versus growth stocks or emerging markets versus developed markets.
3.4 MARKET TECHNICALS