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Self-Fulfilling Risk Panics

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  • Bacchetta, Philippe
  • Tille, Cédric
  • van Wincoop, Eric

Abstract

Recent crises have seen very large spikes in asset price risk without dramatic shifts in fundamentals. We propose an explanation for these risk panics based on self-fulfilling shifts in risk made possible by a negative link between the current asset price and risk about the future asset price. This link implies that risk about tomorrow’s asset price depends on uncertainty about risk tomorrow. This dynamic mapping of risk into itself gives rise to the possibility of multiple equilibria and self-fulfilling shifts in risk. We show that this can generate risk panics. The impact of the panic is larger when the shift from a low to a high risk equilibrium takes place in an environment of weak fundamentals. The sharp increase in risk leads to a large drop in the asset price, decreased leverage and reduced market liquidity. We show that the model can account well for the developments during the recent financial crisis.

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Paper provided by C.E.P.R. Discussion Papers in its series CEPR Discussion Papers with number 7920.

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Date of creation: Jul 2010
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Handle: RePEc:cpr:ceprdp:7920

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Keywords: Financial panic; Sunspot-like equilibria;

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References

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Citations

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Cited by:
  1. Philippe Bacchetta, Cédric Tille, Eric van Wincoop, 2011. "Regulating Asset Price Risk," IHEID Working Papers 02-2011, Economics Section, The Graduate Institute of International Studies.
  2. Tobias Adrian & Erkko Etula & Jan J. J. Groen, 2010. "Financial amplification of foreign exchange risk premia," Staff Reports 461, Federal Reserve Bank of New York.
  3. Philippe Bacchetta & Eric van Wincoop, 2012. "Sudden Spikes in Global Risk," Working Papers 062012, Hong Kong Institute for Monetary Research.
  4. Driscoll, John C. & Holden, Steinar, 2014. "Behavioral Economics and Macroeconomic Models," Finance and Economics Discussion Series 2014-43, Board of Governors of the Federal Reserve System (U.S.).

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