What Does the Risk-Appetite Index Measure?

Explanations of changes in asset prices as being due to exogenous changes in risk appetite, although arguably controversial, have been popular in the financial community and have also received some attention in attempts to account for recent financial crises. Operational versions of these explanations are based on the assumption that changes in asset prices can be decomposed into a part that can be attributed to changes in riskiness and a part attributable to changes in risk aversion, and that some quantitative measure can capture these effects in isolation. One such measure, the risk-appetite index (RAI)—used in the financial community as well as in assessments of financial stability in emerging markets—is based on the rank correlation between assets' riskiness and excess returns. The author seeks to provide a theoretical foundation for this measure. He summarizes the arguments behind the index in two propositions and attempts to derive these propositions within a class of well-specified asset-pricing models. His results indicate that, whereas the exclusive attribution of the rank effect to changes in risk aversion is problematic in general, a specific set of circumstances can be identified in which this attribution is permissible. The key assumption is identified, and its empirical implications are examined. In cases where this assumption is shown to be empirically valid, the model provides a theoretical foundation for the RAI.