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Self-Fulfilling Risk Panics

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Author Info

  • 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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Citations

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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. John C. Driscoll & Steinar Holden, 2014. "Behavioral Economics and Macroeconomic Models," CESifo Working Paper Series 4785, CESifo Group Munich.
  3. Bacchetta, Philippe & van Wincoop, Eric, 2013. "Sudden spikes in global risk," Journal of International Economics, Elsevier, vol. 89(2), pages 511-521.
  4. Adrian, Tobias & Etula, Erkko & Groen, Jan J.J., 2011. "Financial amplification of foreign exchange risk premia," European Economic Review, Elsevier, vol. 55(3), pages 354-370, April.

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