Self-Fulfilling Risk Panics

Philippe Bacchetta, Cédric Tille and Eric van Wincoop

Cahiers de Recherches Economiques du Département d'économie from Université de Lausanne, Faculté des HEC, Département d’économie

Abstract: Recent crises have seen very large spikes in asset price risk without dramatic shifts in fundamentals. We propose an explanation for these risk panics based on self-fulfilling shifts in risk made possible by a negative link between the current asset price and risk about the future asset price. This link implies that risk about tomorrow's asset price depends on uncertainty about risk tomorrow. This dynamic mapping of risk into itself gives rise to the possibility of multiple equilibria and self-fulfilling shifts in risk. We show that this can generate risk panics. The impact of the panic is larger when the shift from a low to a high risk equilibrium takes place in an environment of weak fundamentals. The sharp increase in risk leads to a large drop in the asset price, decreased leverage and reduced market liquidity. We show that the model can account well for the developments during the recent financial crisis.

Keywords: financial; panics; and; sunspot-like; equilibria (search for similar items in EconPapers)
JEL-codes: E44 G01 G11 G12 (search for similar items in EconPapers)
Pages: 36 pages + 8 figures
Date: 2010-06
New Economics Papers: this item is included in nep-ban, nep-bec, nep-cba and nep-mac
References: Add references at CitEc
Citations: View citations in EconPapers (7)

Published in American Economic Review, 102, December 2012, pp. 3674-3700

Downloads: (external link)
http://www.hec.unil.ch/deep/textes/10.05.pdf (application/pdf)

Related works:
Journal Article: Self-Fulfilling Risk Panics (2012)
Working Paper: Self-Fulfilling Risk Panics (2011)
Working Paper: Self-fulfilling risk panics (2011)
Working Paper: Self-Fulfilling Risk Panics (2010)
Working Paper: Self-Fulfilling Risk Panics (2010)
Working Paper: Self-Fulfilling Risk Panics (2010)
Working Paper: Self-Fulfilling Risk Panics (2010)
Working Paper: Self-Fulfilling Risk Panics (2010)
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Persistent link: https://EconPapers.repec.org/RePEc:lau:crdeep:10.05

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