Risk-on/Risk-off: Financial market response to investor fear

•Examine the relationship between changes in the level of investor fear and financial market returns.•Find a statistically significant relationship consistent with a flight to quality as fear increases.•The relationship is more sensitive during periods of market turmoil.•Extreme levels of investor fear have some predictive ability for subsequent returns.•Financial market returns are closely related to prevailing levels of investor fear.

This paper examines the relationship between changes in the level of investor fear (measured by VIX) and financial market returns. We document a statistically significant relationship, across asset classes, consistent with a flight to quality as investor fear increases. As VIX increase there is a decline in stock markets, bond yields, and high-yielding currencies (AUD and NZD), while the USD appreciates. Returns become more sensitive to changes in the level of investor fear during the financial crisis of 2008-09, when investor fear spikes sharply. Analysis of market returns subsequent to periods of extreme levels of investor fear suggests some predictive ability for future returns, and it is suggested that this may be used to develop a profitable trading strategy. Taken together, the results confirm that financial market returns are closely related to prevailing levels of investor fear.