A Rational Expectations Consistent Measure of Risk: Using Financial Market Data from a Middle Income Context

Although economic theory assumes that risk is of central importance in financial decision making, it is difficult to measure the uncertainty faced by investors. Commonly used empirical proxies for risk (such as the moving standard deviation of the returns on an asset) are not firmly grounded in economic theory. Risk measures have been developed by other studies, but these are often based on subjective weights attaching to a range of objective component indicators, are difficult to replicate and are not strictly consistent with underlying theory. The contribution of this article is to develop a methodology to construct rational expectations consistent empirical risk measures. It has the advantages of being explicitly consistent with economic theory and easily replicable. We illustrate this methodology by specific application to the South African context. The time-varying risk measure developed in this article is consistent with a rational expectations application of the expectations hypothesis. The constructed measure is a broad one (it includes political risk and peso problems for instance) and reflects investors' perceptions of systematic risk.