How Much Investors are Willing to Pay for the

Risk?
: Implied Risk Appetite

Kihyung Kim1

Department of Industrial and systems Engineering, Texas A&M

University, College Station, Texas 77843, U.S.A.

Abstract
One of the fundamental questions encountered in finance is how much the price of risk is.
Although capital asset pricing model is ingenious, it explains poorly the price of risky asset in real world.
The major reason for the defect lies on the strong assumptions of rational representative investor and
evident investors’ utility function. Researchers have suggested several ways to operationalize empirical
tests, but none of them is perfect. The aim of this paper is to answer the question about investors’
willingness to pay for risk. The willingness of investors is represented by the Euler equations of
consumption as a price of risk. This research suggests a method to calculate the willingness of investors,
without any assumption about investors’ preference and market efficiency. The proposed method, which
is named as Implied Risk Appetite, shows its adequacy through the result of the empirical research which
is conducted in the Korean market.

Key Words: investors’ sentiment, risk appetite, CCAPM, Euler equation

1 E-mail address: kihyungkim@tamu.edu

2 The unit of trading volume is 10 thousand contracts. Jan. 31st , 2008
How Much Investors are Willing to Pay for the Risk? Kihyung Kim

1. Introduction

One of the fundamental questions encountered in finance is how much the price of risk is. Lucas
(1978) suggested a celebrated theory for the question. However, the abundant empirical evidence
disputes against the theory. The model, which is called consumption based capital asset pricing model,
CCAPM henceforth, is an equilibrium model in exchange economy. Although ingenious, the model
explains poorly the price of risky asset in real world. Mehra and Prescott(1985) indicated that the model
predicts a mean equity premium that is too low and a mean interest rate is too high, using the data of
consumption growth. The major reason for the defect lies on the strong assumptions of rational
representative investor and evident investors’ utility function.
To generalize investors’ utility function, the classical finance researchers have suggested
alternative preference models. For instance, Constantinides(1990) proposed a time-nonseparable
preferences. Weil(1989) and Epstein and Zin(1991) presented a recursive preferences. These models may
mitigate the poor empirical performance of CCAPM, however, they are not sufficient to resolve the
equity premium puzzle by the root. More radical approach can be found in prospect. Tversky and
Kahneman(1979) tried to capture people’s attitudes to risky gambles as parsimoniously as possible. They
found a number of important features which contrast with classical expected utility framework. First
utility is defined over gains and losses rather than over final wealth positions. Second, people are risk
averse over gains, and risk-seeking over losses. The final feature is the nonlinear probability
transformation. Small probabilities are overweighted. So, people are more sensitive to changes in
probabilities at higher probability levels.
Behavioral finance researchers have attacked the problem of rational representative investors.
Equilibrium prices reflect a weighted average of the beliefs of the rational and irrational traders. So long
as each group has significant risk bearing capacity, both influence prices significantly. For example,
DeLong et al. (1990) model the consequences of unpredictable random trades. Investors are of two
types: rational arbitrageurs who are free from sentiment and irrational traders prone to sentiment. They
compete in the market and set prices and expected returns. Rational arbitrageurs with exogenous short
time horizons limit their arbitrage trades for fear that the mispricing will get worse before it gets better.
Therefore, prices are not always at their fundamental values.
It is accepted by both academic researchers and market practitioners that the issue is not
whether the sentiment influence asset price but how to quantify the sentiment and its effect. Academic
researchers are mainly interested in elucidating an atypical occurrence in financial market with investors’

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How Much Investors are Willing to Pay for the Risk? Kihyung Kim

sentiment. The research of Malcolm Baker and Jeffery Wurgler represent a frontier of this field. They
showed that equity issues over total new issues which are including equity and debt issues can be used
to forecast market returns (Baker and Wurgler (2000)). Trading volume is closely related to the liquidity.
From copious liquidity, investors feel stability in trading. It can positively affect the price of risky asset
(Baker and Wurgler (2004)). To aggregate diverse information, they suggested an investors' sentiment
index. With this index, they inspected agreeable hypotheses. As results, they showed that investor
sentiment may have significant effects on the cross-section of stock prices, and it is inclined to be
affected by sentiment that stocks that have certain characteristics such as low capitalization, short
history, unprofitability, high volatility, non-dividend paying and financial distress(Baker and
Wurgler(2006)).
Market practitioners focus their efforts on constructing indexes, which can measure mispricing in
real market. Institutional investors and investment banks announce indexes, which aggregate
information from various financial markets, using statistical method. These include: the JPMorgan
Liquidity, Credit, and Volatility Index, the UBS Investor Sentiment Index, the Merrill Lynch Financial Stress
Index, and the Westpac Risk Appetite Index. On the other hand, central banks and international
organizations implement the indexes based on classical theory. These include: the Tarashev, Tsatsaronis,
and Karampatos Risk-Appetite Index, developed at the Bank for International Settlements; the Gai and
Vause Risk-Appetite Index, developed at the Bank of England; the Credit Suisse First Boston Risk-
Appetite Index; the Kumar and Persaud Global Risk-Appetite Index, used by both the IMF and JPMorgan;
the State Street Investor-Confidence Index; and the Goldman Sachs Risk-Aversion Index.
The remaining task in this area is empirical research. However, finding a bench mark is hard to
elucidate by its nature. This research focuses on this problem. Researchers have suggested several ways
to operationalize empirical tests, but none of them is perfect. The aim of this paper is to answer the
question about investors’ willingness to pay for risk. The willingness of investors is represented by the
Euler equations of consumption as a price of risk. This research suggests a method to calculate the
willingness of investors, without any assumption about investors’ preference and representative agent,
from the information in derivatives.
Section 2 is devoted to introduce the model which is named as Implied Risk Appetite. Section 3
describes empirical results of the Implied Sentiment. Section 4 presents the conclusions of this research.

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2. The Model of Implied Risk Appetite

Lucas, R. E. (1978) suggested an asset pricing model under the general equilibrium approach. It
is important that the pricing model is an absolute pricing model which contains investors’ preference.
The expected rate of return is expressed as

(1)

where, and t means the asset and time respectively. The represents the gross rate of return
of asset and the stands for the risk-free interest rate. The means subjective discount factor. The
connotes the price of risk at time and the is the quantity of risk in each asset at time . They are
explicitly expressed as the following equations.

(2–1)

(2–2)

where, and denote covariance, variance and expectation. Note that the
price of risk depends on the volatility and expectation of the stochastic discount factor. The
stochastic discount factor ( ) denotes the marginal rate of substitution between consumption at time
and consumption at time . That is:

(3)

where, means the consumption at time , and and indicates utility function and
marginal utility function respectively.
Suppose that there are European options on the future consumption. The investors confess their
time preference of consume through the price of options and underlying assets. As shown in (2 – 2), the
price of risk consist of variance and expectation of stochastic discount factors. Assume that investors can
implement ‘conversion’ or ‘reversal’ strategy easily. However, other arbitrage strategies are not practical
in market. The conversion and reversal are the most basic option arbitrage strategies. To implement the

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conversion strategy, a trader purchases an underlying asset and takes long position to a put option and
short position for a call option. These options have the same strike price and maturity. The reversal is the
strategy take opposite position for the assets. When conversion and reversal are activated eagerly, put-
call parity is hold for each strike price and maturity. Let, denote the stricke prices of
options. Therefore, the discount rate can be expressed as:

(4)

where, and denote the time to maturity, put option price, spot price of
underlying asset, call option price and dividend rate respectively. From the above equation, the
stochastic discount factor is derived as following:

(5)

Because other arbitrage strategies are not practical in market, there are arbitrage chances in the
market. When the strike price is given, the expectation and variance of stochastic discount factor can be
rewritten as followings:

(6-1)

(6-2)

Using above equations, the price of risk can be calculated. Note that there is no assumption
about investors’ preference and market efficiency.
The price of risk tends to highly dense near 0. So it is difficult to comprehend investors’
sentiment. In this research, a technical transformation is implemented to overcome this problem.
Eventually the Implied Risk Appetite (IRA) is calculated as

(14)

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How Much Investors are Willing to Pay for the Risk? Kihyung Kim

3. Empirical Analysis of the Implied Risk Appetite

The Implied Risk Appetite shows its adequacy through the result of the empirical research which
is conducted in the Korean market. In this research, the Kospi 200 index is chosen as the proxies of
consumption, because the index is a market portfolio of Korean stock market. The Korean option market
is opened in July 1996. Shortly after its beginning, it suffered the Asian financial crisis in 1997. After
initializing and stabilizing, the market has shown matured behavior from 1999. For this reason, the
research period is refined from 1999 to 2006. The daily data on the KOSPI 200 index option and KOSPI
200 index over the period are obtained from the Korea Exchange. The quantity of option contract is
applied as the weight to compute expectation and variance. Figure 1 shows the time series of Implied
Sentiment during the period.

Figure 1] The Implied Risk Appetite of KOSPI 200 index

The correlation analysis about Implied Risk Appetite and proxies of investors’ sentiment is
conducted to investigate validity. The five items are selected for this research. The first proxy is the put-

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call ratio. The put-call ratio is used as a measure of investors’ sentiment in Dennis and Mayhew (2002).
Bandopadhyaya (2006) showed that it is an explanatory variable. Furthermore the financial stress index
of the Merrill Lynch which is one of well known practical index for risk appetite includes it. The Put-Call
Ratio is computed as following

When the market is expected to perform strongly, the number of call option contracts is
disposed to outnumber the puts’ and vice versa. Therefore, the put-call ratio has negative relationship to
investors’ sentiment. From this relationship, the Implied Risk Appetite is expected to show negative
correlation to the put-call ratio. The data to calculate put-call ratio is acquired from the Korean
exchange. The second is the interest rate spread. The interest rate spread is widely considered as a proxy
to represent investors’ risk appetite. All of indexes which are issued by the investment banks and
institutional investors comprise the spreads on high yield bonds. The wide spread means that investors
require higher return for risky investment, i.e. investors’ sentiment is expected to be on reversal
relationship to the yield spread. The interest rate data to calculate yield spread is obtained from the
Economic Statistics System of the Bank of Korea. The spread is measured between the Korean
government bond and corporate bond which is rated AA-. The third and forth proxy are the won – dollar
exchange rate and won – 100 yen exchange rate. The rate of foreign exchange also represents the
investors’ sentiment. The information of exchange market is an element of atheoretic indexes, even if it
is not a naive exchange rate itself. When investors concern about a market performance, the investors
try to find alternative financial market to invest. In this case, the exchange rate goes up for the deficiency
of foreign currency. Accordingly it is anticipated to be negative that the correlation between the implied
sentiment and exchange rates. In this research, the author chooses two exchange rates, won to dollar
and won to yen rate, because the most important trading partners of Korea are U.S.A and Japan. The
data is also obtained from the Economic Statistics System of the Bank of Korea. The final is trading
volume. Baker and Stein (2004) show that the liquidity and investors’ sentiment are in positively
correlated. The trading volume is closely related to the liquidity. So it is expected that Implied Risk
Appetite and trading volume have positive correlation. The data of trading volume is included in the data
from the Korean exchange.

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How Much Investors are Willing to Pay for the Risk? Kihyung Kim

The table 1 demonstrates the descriptive statistics for the Kospi 200 index, the proxies and
Implied Risk Appetite.

N Mean Standard Deviation Skewness Kurtosis

Kospi200 1972 108.017 33.9246 0.816 -0.233

Put Call ratio 1972 0.968225 0.3940251 2.804 13.826
Spread 1972 0.824637 0.3843296 0.491 -0.54
Won/Dollar 1972 1146.966 108.6715 -0.364 -0.758
Exchange Rate
Won/100Yen 1972 999.853 85.22492 -0.96 0.133
Exchange Rate
Trading volume2 1971 44641.11 24532.211 2.539 10.522
IRA 1972 6.85 2.062 -0.461 0.756

Table 1] Descriptive Statistics for the proxies of investors' sentiment and the implied sentiment

The table 2 shows the correlation between the variables.

Kospi200 Put Call Spread Won/$ Won/100¥ Trading IRA

ratio Exch.Rate Exch.Rate volume
Kospi200 1
Put Call ratio .091(**) 1
Spread -.740(**) .064(**) 1
Won/$ -.841(**) -.067(**) .713(**) 1
Exchange Rate
Won/100¥ -.792(**) -.110(**) .621(**) .746(**) 1
Exchange Rate
Trading -.213(**) -.158(**) -0.013 .328(**) .092(**) 1
volume
IRA .353(**) -.112(**) -.420(**) -.318(**) -.294(**) .045(*) 1

(**) and (*) denote statistical significance at the level 1% and 5%, respectively.
Table 2] Correlations between variables

All of the correlations between Implied Risk Appetite and other proxies are appeared as
expected and statistically significant. This result supports that the Implied Risk Appetite is a measure of

2 The unit of trading volume is 10 thousand contracts.

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investors’ sentiment.

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4. Concluding Remarks

The basic purpose of this paper is to suggest an index of investors’ willingness to pay for risk.
The Implied Risk Appetite is based on the CCAPM that is an absolute equilibrium pricing model of risky
assets. The willingness is reflected on the Euler equation of consumption. The disadvantages of classical
approach are subdued by the limited arbitrage assumption and conditional variance technique. In the
procedure of calculating implied sentiment, no strong assumption is included. Consequently, the implied
sentiment becomes a robust measure of the investors’ willingness. Its validity is supported by the
empirical research of the Korean financial market.

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