Can risk aversion indicators anticipate financial crises?

Virginie Coudert () and Mathieu Gex

Financial Stability Review, 2006, issue 9, 67-87

Abstract: Fluctuations in investor risk aversion are often cited as a factor explaining crises on financial markets. The alternation between periods of bullishness prompting investors to make risky investments, and periods of bearishness, when they retreat to the safest forms of investments, could be at the root of sharp fluctuations in asset prices. One problem in the assessment of these different periods is clearly distinguishing the risk perceived by agents from risk aversion itself. There are several types of risk aversion indicators used by financial institutions (the VIX, the LCVI, the GRAI, etc.). These indices, which are estimated in diverse ways, often show differing developments, although it is not possible to directly assess which is the most accurate. An interesting method in this respect is to link the indicators to financial crises. In principle, financial crises should coincide with periods in which risk aversion increases. Here we estimate probabilities of financial crises –currency and stock market crises– using the different risk aversion indicators as explanatory variables. This allows us to assess their respective predictive powers. The tests carried out show that risk aversion does tend to increase before crises, at least when it is measured by the most relevant indices. This variable is a good leading indicator of stock market crises, but is less so for currency crises.

Date: 2006
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