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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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    File URL: http://www.lse.ac.uk/fmg/workingPapers/discussionPapers/fmgdps/dp647AXA2.pdf
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    References listed on IDEAS

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    Cited by:

    1. 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.
    2. Philippe Bacchetta & Cédric Tille & Eric van Wincoop, 2012. "Self-Fulfilling Risk Panics," American Economic Review, American Economic Association, vol. 102(7), pages 3674-3700, December.
    3. Jürgen Eichberger & Klaus Rheinberger & Martin Summer, 2014. "Credit risk in general equilibrium," Economic Theory, Springer;Society for the Advancement of Economic Theory (SAET), vol. 57(2), pages 407-435, October.
    4. Chollete, Lorán & de la Peña, Victor & Lu, Ching-Chih, 2012. "International diversification: An extreme value approach," Journal of Banking & Finance, Elsevier, vol. 36(3), pages 871-885.
    5. 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.
    6. Tobias Adrian & Erkko Etula, 2010. "Funding liquidity risk and the cross-section of stock returns," Staff Reports 464, Federal Reserve Bank of New York.
    7. Monica Billio & Mila Getmansky & Andrew W. Lo & Loriana Pelizzon, 2010. "Econometric Measures of Systemic Risk in the Finance and Insurance Sectors," NBER Chapters,in: Market Institutions and Financial Market Risk National Bureau of Economic Research, Inc.
    8. Fischer, Thomas & Riedler, Jesper, 2014. "Prices, debt and market structure in an agent-based model of the financial market," Journal of Economic Dynamics and Control, Elsevier, vol. 48(C), pages 95-120.
    9. Aymanns, Christoph & Caccioli, Fabio & Farmer, J. Doyne & Tan, Vincent W.C., 2015. "Taming the Basel leverage cycle," LSE Research Online Documents on Economics 65089, London School of Economics and Political Science, LSE Library.
    10. 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.
    11. 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.
    12. Christoph Aymanns & Fabio Caccioli & J. Doyne Farmer & Vincent W. C. Tan, 2015. "Taming the Basel Leverage Cycle," Papers 1507.04136, arXiv.org.
    13. Michael Woodford, 2010. "Financial Intermediation and Macroeconomic Analysis," Journal of Economic Perspectives, American Economic Association, vol. 24(4), pages 21-44, Fall.
    14. repec:eee:jbfina:v:80:y:2017:i:c:p:215-234 is not listed on IDEAS
    15. Gabriele Galati & Richhild Moessner, 2013. "Macroprudential Policy – A Literature Review," Journal of Economic Surveys, Wiley Blackwell, vol. 27(5), pages 846-878, December.
    16. Chollete, Loran & Ning, Cathy, 2009. "The Dependence Structure of Macroeconomic Variables in the US," UiS Working Papers in Economics and Finance 2009/31, University of Stavanger.
    17. Aymanns, Christoph & Caccioli, Fabio & Farmer, J. Doyne & Tan, Vincent W.C., 2016. "Taming the Basel leverage cycle," Journal of Financial Stability, Elsevier, vol. 27(C), pages 263-277.
    18. Chollete, Loran & Ning, Cathy, 2010. "Asymmetric Dependence in US Financial Risk Factors?," UiS Working Papers in Economics and Finance 2011/2, University of Stavanger.
    19. Aymanns, Christoph & Farmer, J. Doyne, 2015. "The dynamics of the leverage cycle," Journal of Economic Dynamics and Control, Elsevier, vol. 50(C), pages 155-179.
    20. 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.
    21. Valentin Haddad, 2012. "Concentrated Ownership and Equilibrium Asset Prices," 2012 Meeting Papers 902, Society for Economic Dynamics.
    22. Ekaterina Svetlova & Henk van Elst, 2012. "How is non-knowledge represented in economic theory?," Papers 1209.2204, arXiv.org.

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