Changes in Investors' Risk Appetite - An Assessment of Financial Integration and Interdependence

Investors' attitude towards risk is a key factor driving the movement in asset prices. Global reduction in investors' risk appetite has coincided with episodes of global financial market correction. In this paper, we derive a measure for risk appetite based on the methodology of Gai and Vause (2006) for investors in the US, the UK, Germany, Japan, and Hong Kong, and use them to help assess the issues of financial integration and financial market interdependence. Indicators are constructed to gauge the relationship between the risk appetite and the extent of financial integration between these stock markets. The results from the indicators point to very limited financial integration between these five financial markets. Furthermore, the degree of co-movement between risk appetite measures and the stock and bond market performance is examined using the dynamic conditional correlation. The empirical results reveal that there exists interdependence between the changes in the risk appetite and the stock market returns in the US, Japan and Hong Kong, while the "flight-to-quality" phenomenon is apparent in the bond market of the five economies.