Time-Varying Risk Aversion and International Stock Returns

We estimate an aggregate time-varying risk aversion function using option, stock return and macroeconomic data for a sample of 8 countries. We document that, in most of the countries, the degree of risk aversion is countercyclical. Moreover, we show that the estimated risk aversion function forecasts monthly stock index returns up to 12 months ahead. This effect is statistically significant in panel regressions, and it survives the inclusion of additional control variables. Finally, we show that the estimated time-varying risk aversion function provides useful information to an investor who aims at timing the market. An investment strategy that uses the estimated time-varying risk aversion measure to solve a mean-variance asset allocation problem, delivers significant returns.