Cross-country and intertemporal indexes of risk aversion

One of the most common and firmly held views of financial economics is that investors are averse to risk. Although a formal description of risk aversion was proposed by the celebrated mathematician, Daniel Bernoulli, as early as 1738, financial economists are still puzzled about many aspects of risk aversion, including the fact that the realised premium of equities over a risk free asset is too large to accord with ‘normal’ notions of risk aversion. This discrepancy is known as the equity risk premium puzzle. There is also vigorous debate as to the effect of horizon on the willingness of investors to bear risk. To help address these issues and other questions related to risk aversion, a methodology is introduced to infer risk aversion from global portfolio flows and holdings. Specifically, the authors derive a formula for risk aversion based on the assumption that investors maximise expected utility by allocating their portfolio between assets of differing risk. The authors use this formula to approximate the risk aversion of US investors towards specific countries. They demonstrate that risk aversion, as they approximate it, helps to predict bond and stock returns, as well as risk premiums one period forward.