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#ExtremeEvents and short term reversals in #RiskAversion

Posted on April 17th, 2017

#EconomicsDepartment@Rutgers

04/17/2017 @ 101 NJ Hall, 75 Hamilton Street, New Brunswick, NJ

Kim Oosterlinck @FreeUniversityOfBrussels presented work done by Matthieu Gilson, Kim Oosterlinck, Andrey Ukhov. Kim started by reviewing the literature that shows no consensus on whether risk aversion increases or decreases in following extreme events such as war. In addition, these studies often have only two points on which to make this evaluation.

He presented a method for tracking overall risk aversion within a population on a daily basis for several years. His analysis values the lottery part of Belgian bonds which consisted of a fixed coupon bond with the opportunity to win a cash prize every month. These bonds were sold to retail customers and made up 11% of Belgian bond market in 1938. By discounting the cash flows based on the yields for other, fixed coupon Belgian bonds, one can compare the risk neutral price (RNP) relative to the market price (MP).

When MP/RNP > 1 this indicates the average holder is risk loving.

There are three  periods in their observations from 1938 to 1948.

  1. Risk neutral to risk averse from 1938 to 1940, when German invaded and occupied Belgian
  2. Risk aversion to risk seeking from 1940 to 1945 during the German occupation
  3. Risk seeking to risk neutral from 1945 to 1948.

Lots of competing theories on when people become more or less risk averse

These data give the strongest support is habituation to background risk as the best explanation of the increase in risk aversion. Prospect theory also does well as an explanation.

[The findings of increased risk seeking form 1940 to 1945 could also be consistent with a flat yield curve at 3% from 1month to 3 years in 1940 to a steep yield curve in 1945 going from 0% at 1 month to 3% at 3 years. ]

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