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Self-Fulfilling Risk Panics

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  • Bacchetta, Philippe

    (University of Lausanne, CEPR)

  • Tille, Cédric

    (Graduate Institute, Geneva, CEPR)

  • Wincoop, Eric

    (University of Virginia, NBER)

Abstract

Recent crises have seen large spikes in asset price risk without dramatic shifts in fundamentals. We propose an explanation for these risk panics, based on selfful filling shifts in beliefs about risk, that are driven by a negative link between the current asset price and risk about the future asset price. This link implies that risk about the future asset price depends on uncertainty about future risk. This dynamic mapping of risk into itself gives rise to the possibility of multiple equilibria and can generate risk panics. In a panic, risk beliefs are coordinated around a macro fundamental that becomes a sudden focal point of the market. The magnitude of the panic is larger the weaker this macro fundamental. The sharp increase in risk leads to a large drop in the asset price, decreased leverage and reduced market liquidity. While the model is not aimed at modeling the specifics of any particular financial crisis, we show that its implications are broadly consistent with what happened during the 2007-2008 crisis.

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Paper provided by Banco Central de Reserva del Perú in its series Working Papers with number 2011-003.

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Date of creation: Feb 2011
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Handle: RePEc:rbp:wpaper:2011-003

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Cited by:
  1. Philippe Bacchetta & Cédric Tille & Eric van Wincoop, 2011. "Regulating Asset Price Risk," Cahiers de Recherches Economiques du Département d'Econométrie et d'Economie politique (DEEP) 11.02, Université de Lausanne, Faculté des HEC, DEEP.
  2. 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.).
  3. 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.
  4. Bacchetta, Philippe & van Wincoop, Eric, 2013. "Sudden spikes in global risk," Journal of International Economics, Elsevier, vol. 89(2), pages 511-521.

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