This paper analyzes the Risk Appetite Index (RAI), a measure of investors’ risk aversion proposed by Kumar and Persaud (2001, 2002). We show that the RAI distinguishes between risk and risk aversion only under theoretically restrictive assumptions on the distribution of returns and the shocks affecting assets’ riskiness. However, by comparing the RAI with a measure of risk aversion derived from the CAPM — a model that does not require those restrictive assumptions — we find that estimates are surprisingly similar. We explain this result by proving that, under a certain condition, the RAI can approximate the risk aversion parameter of a CAPM. This occurs if the ratio between the variance of the returns on assets and the variance of the riskiness of assets is sufficiently small—a condition that is met in our sample.
Published in 2009 in: International Finance, v. 12, 2, pp. 123-150
