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When market conditions are perceived as stable according to the market indicators used by the index, they are of necessity optimum for investors to be in risk-seeking mode. Equally, when market conditions are unstable, this is synonymous with investor risk-aversion or avoidance. The focus for such an analytical tool has been the investor community. However, currency speculators and corporations can also use a risk appetite or instability indicator with which to trade or manage their currency risk.
Using the context of the 1997–1998 crisis period, the Instability Index seeks to measure risk appetite using leverage, credit spreads and cross-market (equity, fixed income and foreign exchange) options’ volatilities as its three benchmarks. The period of June 1997–September 1998 accelerated the focus in trying to measure risk appetite as first the Asian countries experienced currency crises one after another and then Russia devalued and defaulted in August 1998. Conceptually, everyone knew what it meant to be risk-averse, but measuring it was another matter, let alone trying to use that measurement to predict future phases of risk appetite. While investment banks needed analytical tools to track the overall risk appetite of clients across markets, particularly in times of stress, academics and policymakers also needed such a tool for the purpose of measuring just how orderly or disorderly market conditions were in order to help guide future policy responses. The Instability Index, which was formalized in 1999, is just such a guide and includes three main components:
De-leveraging — There are two parts to this. The first looks at the relationship in the currency market between the US dollar (as an equity-linked, higher yielding asset) and the likes of the Swiss franc (as a traditional safe-haven currency) and Japanese yen (as a low interest rate, funding currency). During times of market stress, the US dollar tends to lose ground against these as “leverage” or risk is cut. The second component looks at US and European bank equities as a measure of market “leverage”.
Credit spreads — In the US dollar credit markets, this tracks the spreads between BBB-rated industrial credits, emerging market Brady bonds and swaps to Treasuries, while it also tracks Euro swap spreads to Bunds. The overall reading gives a very good indicator of investor risk-tolerance.
Implied volatilities — Across the three asset classes of equities, debt and currencies, tracking three-month implied volatilities gives a good idea as to demand levels for option-related protection structures from investors. Option implied volatility tends to rise more sharply during asset market slumps than when asset prices are rising.
The advantage with the readings within this index is that they are relatively easily available and updated daily. Thus, using these three components to represent the degree of “stability” or “instability” in the market, we can have a daily indicator of risk appetite, which can in turn be used as a forecasting tool for currency markets.

Within such a cycle, there is obviously a substantial amount of intraday and intraweek volatility, reflecting swings in market sentiment. Traditionally, economists have either ignored such short- term periods or suggested they could not be predicted. While flow and technical analysis have done much to dispel such a view, recent work on the relationship between “risk appetite” and asset prices has made a real breakthrough in terms of being able to predict those short-term swings in sentiment and in turn how they affect currency and asset prices. Risk appetite or market sentiment are not easily definable concepts given that what these are focusing on is the investor’s willingness or otherwise to invest — which is not always based on logic! Despite such difficulties, the private sector has over the past few years been hard at work creating “risk appetite indicators” to measure overall conditions for risk tolerance across currency and asset markets. Within the investment banks, JP Morgan created its “LCPI Index” Bank of America has its “Global Hazard Indicator” and Salomon Smith Barney its “Instability Index”. For the purpose of an example, we will focus on the Instability Index. The index was originally created to track levels of risk appetite or conversely “instability” for fixed income investors. However, because it uses cross-market indicators for this purpose, we can also use it for managing and trading currency risk.
Risk appetite has become an increasingly important concept, not just because of the need to create more accurate models for forecasting short-term currency moves, but also because the last few years have shown a marked pick-up in cross-asset market volatility. Indeed, one can go as far as to suggest that as the globalization of capital flows has proceeded, so volatility has increased. Risk appetite is essentially a capital flow event and its relationship is directly proportional to the size of capital flows involved. For this very reason, just as capital flows across borders have grown exponentially, so the degree to which capital flows affect currency markets has grown proportionately. A crisis in one country is no longer isolated but is transmitted instantly around the global financial system. Investors who face losses in that one market may seek to take profit on other positions in order to offset those losses, thus creating a domino effect in hitherto unrelated markets.
Extreme bouts of cross-market volatility such as were seen in the wake of the ERM, Mexican and Russian currency crises prompted interest in creating risk appetite indicators which, if not predicting actual crises themselves, would at least be able to predict significant moves in terms of general investor risk tolerance. For this purpose, categories or levels of risk tolerance also had to be created. The three generally accepted categories within most such risk appetite models for this purpose are:
Risk-seeking
Risk-neutral
Risk-aversion
As the focus of the Instability Index is on market volatility and “instability” for the purpose of alerting investors to such bouts of unwanted volatility, these categories can be modified slightly for the purpose of focusing on such instability:
Stable
Neutral
Unstable