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Risk Appetite and Endogenous Risk

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  • Jean-Pierre Zigrand
  • Hyun Song Shin
  • Jon Danielsson

Abstract

Risk is endogenous. Equilibrium risk is the fixed point of the mapping that takes perceived risk to actual risk. When risk-neutral traders operate under Value-at-Risk constraints, market conditions exhibit signs of fluctuating risk appetite and amplification of shocks through feedback effects. Correlations in returns emerge even when underlying fundamental shocks are independent. We derive a closedform solution of equilibrium returns, correlation and volatility by solving the fixed point problem in closed form. We apply our results to stochastic volatility and option pricing.

Suggested Citation

  • Jean-Pierre Zigrand & Hyun Song Shin & Jon Danielsson, 2010. "Risk Appetite and Endogenous Risk," FMG Discussion Papers dp647, Financial Markets Group.
  • Handle: RePEc:fmg:fmgdps:dp647
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    8. Cathy Q. Ning & Loran Chollete, 2009. "The Dependence Structure of Macroeconomic Variables in the US," Working Papers 005, Ryerson University, Department of Economics.
    9. Valentin Haddad, 2012. "Concentrated Ownership and Equilibrium Asset Prices," 2012 Meeting Papers 902, Society for Economic Dynamics.
    10. Anginer, Deniz & Demirguc-Kunt, Asli, 2014. "Has the global banking system become more fragile over time?," Journal of Financial Stability, Elsevier, vol. 13(C), pages 202-213.
    11. Chollete, Loran & Pena, Victor de la & Lu, Ching-Chih, 2009. "International Diversification: A Copula Approach," UiS Working Papers in Economics and Finance 2009/27, University of Stavanger.
    12. Tobias Adrian & Erkko Etula, 2010. "Funding liquidity risk and the cross-section of stock returns," Staff Reports 464, Federal Reserve Bank of New York.
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    15. Ekaterina Svetlova & Henk van Elst, 2012. "How is non-knowledge represented in economic theory?," Papers 1209.2204, arXiv.org.
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    19. Chollete, Lorán & de la Peña, Victor & Lu, Ching-Chih, 2011. "International diversification: A copula approach," Journal of Banking & Finance, Elsevier, vol. 35(2), pages 403-417, February.
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    21. Tyler Muir & Erkko Etula & Tobias Adrian, 2011. "Broker-Dealer Leverage and the Cross-Section of Stock Returns," 2011 Meeting Papers 1448, Society for Economic Dynamics.
    22. Chollete, Loran & de la Pena , Victor & Lu, Ching-Chih, 2009. "International Diversification: An Extreme Value Approach," UiS Working Papers in Economics and Finance 2009/26, University of Stavanger.
    23. Chollete, Loran & Ning, Cathy, 2010. "Asymmetric Dependence in US Financial Risk Factors?," UiS Working Papers in Economics and Finance 2011/2, University of Stavanger.

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