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Risk Appetite and Endogenous Risk

  • Jean-Pierre Zigrand

    ()

  • Hyun Song Shin

    ()

  • Jon Danielsson

    ()

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.

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File URL: http://www.lse.ac.uk/fmg/workingPapers/discussionPapers/fmgdps/dp647AXA2.pdf
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Paper provided by Financial Markets Group in its series FMG Discussion Papers with number dp647.

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Date of creation: Feb 2010
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Handle: RePEc:fmg:fmgdps:dp647
Contact details of provider: Web page: http://www.lse.ac.uk/fmg/

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  1. Basak, Suleyman & Croitoru, Benjamin, 2000. "Equilibrium Mispricing in a Capital Market with Portfolio Constraints," Review of Financial Studies, Society for Financial Studies, vol. 13(3), pages 715-48.
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  4. Jon Danielsson & Jean-Pierre Zigrand, 2006. "Equilibrium asset pricing with systemic risk," LSE Research Online Documents on Economics 24515, London School of Economics and Political Science, LSE Library.
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  9. Yeung Lewis Chan & Leonid Kogan, 2002. "Catching Up with the Joneses: Heterogeneous Preferences and the Dynamics of Asset Prices," Journal of Political Economy, University of Chicago Press, vol. 110(6), pages 1255-1285, December.
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  12. Black, Fischer, 1990. "Mean Reversion and Consumption Smoothing," Review of Financial Studies, Society for Financial Studies, vol. 3(1), pages 107-14.
  13. Stephen Morris & Hyun Song Shin, 2003. "Liquidity Black Holes," Cowles Foundation Discussion Papers 1434, Cowles Foundation for Research in Economics, Yale University.
  14. Stephen Morris & Hyun Song Shin, 2004. "Liquidity Black Holes," Review of Finance, European Finance Association, vol. 8(1), pages 1-18.
  15. Jon Danielsson & Hyun Song Shin & Jean-Pierre Zigrand, 2004. "The impact of risk regulation on price dynamics," LSE Research Online Documents on Economics 16628, London School of Economics and Political Science, LSE Library.
  16. Pavlova, Anna & Rigobon, Roberto, 2008. "The Role of Portfolio Constraints in the International Propagation of Shocks," CEPR Discussion Papers 6647, C.E.P.R. Discussion Papers.
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  18. Woodford, Michael, 1986. "Stationary sunspot equilibria in a finance constrained economy," Journal of Economic Theory, Elsevier, vol. 40(1), pages 128-137, October.
  19. Tobias Adrian & Hyun Song Shin, 2008. "Financial intermediary leverage and value at risk," Staff Reports 338, Federal Reserve Bank of New York.
  20. Xiong, Wei, 2001. "Convergence trading with wealth effects: an amplification mechanism in financial markets," Journal of Financial Economics, Elsevier, vol. 62(2), pages 247-292, November.
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