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Self-Fulfilling Risk Panics

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  • Philippe Bacchetta

    (University of Lausanne, Centre for Economic Policy Research and Hong Kong Institute for Monetary Research)

  • Cedric Tille

    (Graduate Institute, Geneva, Centre for Economic Policy Research and Hong Kong Institute for Monetary Research)

  • Eric van Wincoop

    (University of Virginia, National Bureau of Economic Research and Hong Kong Institute for Monetary Research)

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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Bibliographic Info

Paper provided by Hong Kong Institute for Monetary Research in its series Working Papers with number 282010.

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Length: 44 pages
Date of creation: Nov 2010
Date of revision:
Handle: RePEc:hkm:wpaper:282010

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Cited by:
  1. Philippe Bacchetta & Cedric Tille & Eric van Wincoop, 2011. "Regulating Asset Price Risk," American Economic Review, American Economic Association, vol. 101(3), pages 410-12, May.
  2. Bacchetta, Philippe & van Wincoop, Eric, 2013. "Sudden spikes in global risk," Journal of International Economics, Elsevier, vol. 89(2), pages 511-521.
  3. 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.).
  4. 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.

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