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Self-Fulfilling Risk Panics

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Author Info

  • Philippe Bacchetta
  • Cédric Tille
  • Eric van Wincoop

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 Université de Lausanne, Faculté des HEC, DEEP in its series Cahiers de Recherches Economiques du Département d'Econométrie et d'Economie politique (DEEP) with number 10.05.

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Length: 36 pages + 8 figures
Date of creation: Jun 2010
Date of revision:
Handle: RePEc:lau:crdeep:10.05

Contact details of provider:
Postal: Université de Lausanne, Faculté des HEC, DEEP, Internef, CH-1015 Lausanne
Phone: ++41 21 692.33.64
Fax: ++41 21 692.33.05
Email:
Web page: http://www.hec.unil.ch/deep/publications/cahiers/series
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Keywords: financial panics and sunspot-like equilibria;

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References

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Cited by:
  1. 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.
  2. Philippe BACCHETTA & Cedric TILLE & Eric VAN WINCOOP, . "Regulating Asset Price Risk," Swiss Finance Institute Research Paper Series 11-04, Swiss Finance Institute.
  3. John C. Driscoll & Steinar Holden, 2014. "Behavioral Economics and Macroeconomic Models," CESifo Working Paper Series 4785, CESifo Group Munich.
  4. Philippe Bacchetta & Eric van Wincoop, 2012. "Sudden Spikes in Global Risk," Working Papers 062012, Hong Kong Institute for Monetary Research.

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