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Reflexivity in Credit Markets

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Listed:
  • Robin Greenwood
  • Samuel G. Hanson
  • Lawrence J. Jin

Abstract

Reflexivity is the idea that investors' biased beliefs affect market outcomes, and that market outcomes in turn affect investors' beliefs. We develop a behavioral model of the credit cycle featuring such a two-way feedback loop. In our model, investors form beliefs about firms' creditworthiness, in part, by extrapolating past default rates. Investor beliefs influence firms' actual creditworthiness because firms that can refinance maturing debt on favorable terms are less likely to default in the short-run—even if fundamentals do not justify investors' generosity. Our model is able to match many features of credit booms and busts, including the imperfect synchronization of credit cycles with the real economy, the negative relationship between past credit growth and the future return on risky bonds, and "calm before the storm" periods in which firm fundamentals have deteriorated but the credit market has not yet turned.

Suggested Citation

  • Robin Greenwood & Samuel G. Hanson & Lawrence J. Jin, 2019. "Reflexivity in Credit Markets," NBER Working Papers 25747, National Bureau of Economic Research, Inc.
  • Handle: RePEc:nbr:nberwo:25747
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    References listed on IDEAS

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    Cited by:

    1. Arvind Krishnamurthy & Wenhao Li, 2020. "Dissecting Mechanisms of Financial Crises: Intermediation and Sentiment," NBER Working Papers 27088, National Bureau of Economic Research, Inc.
    2. Da, Zhi & Huang, Xing & Jin, Lawrence J., 2021. "Extrapolative beliefs in the cross-section: What can we learn from the crowds?," Journal of Financial Economics, Elsevier, vol. 140(1), pages 175-196.
    3. Liao, Gordon Y., 2020. "Credit migration and covered interest rate parity," Journal of Financial Economics, Elsevier, vol. 138(2), pages 504-525.
    4. Matthew Baron & Emil Verner & Wei Xiong, 0. "Banking Crises Without Panics," The Quarterly Journal of Economics, Oxford University Press, vol. 136(1), pages 51-113.
    5. Gordon Y. Liao, 2019. "Credit Migration and Covered Interest Rate Parity," International Finance Discussion Papers 1255, Board of Governors of the Federal Reserve System (U.S.).

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    JEL classification:

    • G01 - Financial Economics - - General - - - Financial Crises
    • G40 - Financial Economics - - Behavioral Finance - - - General

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