Back Matter
  • 1 https://isni.org/isni/0000000404811396, International Monetary Fund

APPENDIX I

Factors Behind Shifts in Investor Risk Appetite

A shift in risk appetite may reflect the level of risk appetite in the preceding period: optimism or pessimism feeds upon itself, propelled by belief that there has been a “fundamental” change for the better, or for worse. Tversky and Kahneman (1974, 1979) and more recently Shiller (1998) suggest that that the precepts of rational, optimizing behavior are frequently violated in real life. They also showed that these “anomalies” could be predicted. In their 1974 paper Tversky and Kahneman argued that individuals rely on a limited number of heuristic principles that serve to simplify complex probability judgments. Usually these “short-cut” decision-making tools work fairly well—that is, approximate to rational economic behavior but under certain circumstances they result in systematic errors of judgment. For instance, under the Availability Heuristic, individuals assess the probability of an event by the ease with which instances can be called to mind, rather than by its actual probability distribution. Thus, people will generally assume that their chances of being involved in an airline disaster are higher if there has recently been a high profile instance of a crash.

The cyclical nature of risk appetite noted above may reflect, in part, the influence of this model of decision-making. The self-reinforcing nature of upswings and downturns, driven to a degree by investors’ expectations, could reflect the fact that during an upswing (a period of high and/or rising risk appetite) high levels of return are easily called to mind and the possibility of a crisis is more distant in the memory. In short, the probability of continuation of the high yields obtained through investment in risky assets is seen as disproportionately probable since this is what recent experience indicates. Conversely, during a downturn the probability of continued economic woes continuing is accorded a disproportionately high weight in the investors’ minds; and so risk appetite falls, safe havens seem all the safer and the downside risk associated with high-yielding assets looms large in the minds of investors.

This process continues until extremes appear to be reached over the risk-appetite “cycle”. The extremes are invariably followed by events that call these beliefs into question, and engender uncertainty. This period was described by Kindleberger (1978) as one of “distress” and represents, for him, the uneasy period between “mania” and “panic”. That is, there appears to be a sharp turning point triggered by events which in a more neutral environment would not warrant a large response. An abrupt and sharp reappraisal set in train by this “trigger” then reverses the cycle.

Two examples: consider first the sharp compression in emerging market spreads that occurred in 1996. Investor flows into emerging market debt were buoyed by a general belief that the fundamentals for these economies were significantly better and improving. In the event, most economies, regardless of the fundamentals and policies, benefited. The spreads were driven down to levels which were inadequate for the risks in many of these markets, underlining the increase in investors’ appetite for risk. This increased the probability that there could be a sharp reappraisal of the risk/return nexus on any disappointment, and as a consequence of the new uncertainty, a general decline in the willingness to take risk. This is what happened following concerns about current accounts and the short-term debt situation of a number of these countries. A reappraisal of a specific risk led to a general reassessment of the willingness to take risk.

It is possible that the extent of this impact is not constant in every situation and is likely to reflect the degree to which investors believe that a fundamental change has occurred. Thus, the sharp compression in emerging market spreads in 1996 could be connected to the “new paradigm” that was perceived to have occurred. The Tiger economies of the Southeast Asian region had experienced rapid and sustained economic growth over a long period. The East Asian Miracle had been widely hailed as a new paradigm for the developing world, with other less developed countries urged to follow suit. Consequently, and despite the large differences in their individual economic and political structures, the countries of Southeast Asia benefited, as a perceived homogeneous group, from rising investors’ risk appetite in the region. This phenomenon may be related to the ‘Representative Heuristic’ (Tversky and Kahneman, 1974). Under this heuristic, probabilities are evaluated by the degree to which an event is representative of (or similar to) a class of events or objects, rather than by its actual probability distribution. If probabilities are evaluated, at least to some extent, by the degree to which an asset is perceived as being similar to another—or representative of a particular class - then we would expect assets viewed as similar to move together. Thus, for example, currencies viewed as similarly risky (perhaps due to similarities in political, cultural or geographical factors) would show high degrees of correlation independently of differences in economic fundamentals.

However, it is also possible that the favorable shift in investor sentiment vis- à -vis Southeast Asia had a more general impact, in that the prospects for all emerging markets and developing countries seemed to be enhanced. If very high levels of productivity growth over many years were possible in Southeast Asia, then perhaps the same was also possible elsewhere. Consequently, high levels of risk appetite for the Southeast Asian region resulted in “positive contagion” as levels of risk appetite for all emerging markets rose.

The flip-side of this coin is that when the Asian crisis hit, not only was the level of risk appetite for that region affected, as investors realized that the “new paradigm” was flawed after all, but appetite for risk in all emerging markets was sharply reduced. If as has been argued, the success of Southeast Asia offered the chance, in the minds of investors, for other emerging markets and developing countries to follow suit, the realization that this was not the case dealt a blow to their prospects and hence the level of risk appetite vis- à -vis all emerging markets declined. This may, in part, explain the relatively higher level of contagion in the Asian crisis than in the Mexican crisis. Prior to the onset of the latter there was no talk of a new paradigm and, it may be that investors were not shocked by another crisis in that region and therefore did not alter their appetite for risk with regard to other developing countries.

A second example relates to the sharp deterioration in market conditions following the collapse of LTCM in September 1998. Market sentiment was already adversely affected following the Russian debt default and devaluation in August. It led to a substantial reappraisal of not only emerging market prospects, but also of risks more generally, with investors’ appetite for risk appetite being adversely affected. This led to, but was magnified significantly by the LTCM collapse. However, in that extreme event, prompt and aggressive response by the US Federal Reserve to provide unlimited liquidity, and lower the Fed funds rate, had a salutary positive impact on investors’ appraisal of risks. Risk appetite appears to have rebounded sharply, and continued to increase subsequently in the run up to the millennium

The sharp decline in risk appetite following the collapse of LTCM may represent another example of a “new paradigm” proving to be illusory. The sophisticated quantitative models used by LTCM, and designed by Nobel-prize-winning economists, offered the prospect of guaranteed high returns with minimum risk. Thus it can be assumed that their success offered the industry the prospect of enjoying similar rewards through the employment of similar methods. Consequently, with the collapse came the question: if LTCM with all their skill and high-technology techniques are not safe, what chance do the rest of us have? Thus general levels of risk appetite fell precipitously. However, the fact the Fed’s intervention was able to rescue this situation perhaps reflects the fact that another paradigm was seen to be more powerful: that paradigm can be summarized as ‘don’t fight the Fed’, a reflection of the perceived omniscience, not to say omnipotence, of Federal Reserve Chairman, Alan Greenspan. So, if we assume that investors’ appetite for risk is ultimately supported, at least to some extent, by faith in the ability of Greenspan et al to rescue any situation, then the consequences on levels of risk appetite, were this paradigm to prove illusory as well could be profound.

If hedge funds have a markedly higher appetite for risk than, say, institutional investors, then a decline in the proportion of market positions being held by hedge funds could reduce the market’s overall appetite for risk. In the wake of the LTCM crisis, the underperformance of “value investing” and new disclosure requirements from their creditors, a number of the large macro-bet hedge funds (including the Tiger and Quantum funds) decided to downsize or even shut up shop completely during 2000 when investors’ appetite for risk also began to fall. As risk appetite recovered in late 2000 and early 2001, there was evidence of a renaissance of hedge funds. An increased role of hedge funds can in turn amplify general increase in risk appetite.

An example from the literature of this process is Kindleberger’s (1978) distinction between “insiders” and “outsiders”. Kindleberger argued that, at some point in the generation of a bubble, “insiders”, who are aware of the situation, sell out at the top of the market to “outsiders” eager to get on the bandwagon. It would seem probable that the risk appetite of such gambling-inclined “outsiders” will be higher than the insiders they replace; thus the overall level of risk appetite is increased and the bubble continues to grow. A possible recent example of this phenomenon is the internet bubble, during the later stages of which many small private investors, seeing the gains to be made, entered the market, replacing professional insiders who were able to take their gains before the bubble burst. Also, the insider/outsider distinction may be applicable to the domestic/foreign investor divide. Thus insiders (domestic investors) may have greater knowledge of their own economy and, seeing a crisis looming before the outsiders (foreign investors), sell their positions at the top of the market.

APPENDIX II

Testing the Risk Appetite Index Distribution

The following table provides the results of statistical analysis which test whether currency returns in a risk averse environment are from a different distribution to the returns of a risk loving period. The skewness provides a measure of the distributions asymmetry. Kurtosis indicates how peaked or flat the distribution is. A normal distribution has a skew of 3, values greater than three reveal a relatively peaked (leptokurtic) distribution, while values below 3 are platykurtic or flatter than a normal distribution. The Jarque-Bera tests whether each distribution is normal. It is distributed as χ2 with 2 degrees of freedom. A low Jarque-Bera probability indicates a rejection of the null hypothesis of normality.

The lower panel of the table tests whether the two distributions are equal, for each statistic a probability value is provided to show whether the null hypothesis of equality is rejected. The first row is a mean equality test which is t-test statistic, which rejects equality. In the second row the equality of the medians is rejected by the Mann-Whitney U test statistic. In the final row the Brown-Forsythe test statistic indicates that the variances of the two distributions are significantly different.

Table 7.

Low and High Risk Appetite States

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1

IMF and State Street Bank, London, respectively. We are grateful to Natalia Alvarez-Grijalba, and Sreekala Kochugovindan, of State Street Bank, and to Ken Kashiwase for statistical support, and to Stephen Sprat for his contribution on the psychology of financial behavior. We also thank Montek S. Ahluwalia, Peter Clark, Gaston Gelos, Ron Johannes, Charles Kramer, Paulo Leme, Guy Meredith, Michael Mussa, Torsten Slok, Amadou Sy, Tony Richards, Kenneth Rogoff and Jeromin Zettelmeyer for discussion and comments. The paper was written when Avinash Persaud was a Visiting Scholar at the IMF, and he is grateful for the hospitality of the Research Department.

3

There is a large literature in this area; see, for instance, Caramazza et al (op.cit).

4

See Shiller (1998) on fads and irrationalities in financial markets.

5

A decline in growth would likely be accompanied by a fall in interest rates and have two effects with ambiguous implications for risk appetite: a desire to attain better returns by moving into riskier assets—an increase in risk appetite, or a signal that economic developments are likely to be worse than anticipated—leading to a decrease in risk appetite.

6

Prior to October 1994, due to lack of data we replace spot and forward exchange rate data from Argentina, Czech Republic, Euro Area, Mexico and Poland with data from the Netherlands, Belgium, Germany, Italy and France.

7

Note that as it is important to obtain a measure of underlying risk, return volatility is computed over the preceding year. Computing the measure with risk measured over a shorter period, say the preceding six months does not materially change the results.

8

LTCM formally informed investors in a letter on September 2 that the value of the fund was down 44 percent in August and 52 percent for the year, but markets had begun to anticipate large losses at LTCM several days before the formal notification.

9

For detailed rationale of this, and the methodology, see Persaud (1998).

10

We have to be careful when interpreting the estimated coefficient provided by the probit. In an OLS regression the slope coefficient provides the marginal effect of a unit change in the regressors on the dependent variable. However, in the probit model, the coefficient is the change in the probability of an event given a unit change in the value of the regressor.

Pure Contagion and Investors Shifting Risk Appetite: Analytical Issues and Empirical Evidence
Author: Mr. Manmohan S. Kumar and Mr. Avinash Persaud