Abstract

http://ssrn.com/abstract=1638932
 
 

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Self-Fulfilling Risk Panics


Philippe Bacchetta


University of Lausanne; Swiss Finance Institute; Centre for Economic Policy Research (CEPR)

Cédric Tille


Graduate Institute of International and Development Studies (HEI)

Eric Van Wincoop


University of Virginia - Department of Economics; National Bureau of Economic Research (NBER)

June 28, 2010

Swiss Finance Institute Research Paper No. 10-32

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.

Number of Pages in PDF File: 50

Keywords: Financial Panics, Sunspot-Like Equilibria

JEL Classification: E44, G01, G11, G12

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Date posted: July 13, 2010 ; Last revised: July 16, 2010

Suggested Citation

Bacchetta, Philippe and Tille, Cédric and van Wincoop, Eric, Self-Fulfilling Risk Panics (June 28, 2010). Swiss Finance Institute Research Paper No. 10-32. Available at SSRN: http://ssrn.com/abstract=1638932 or http://dx.doi.org/10.2139/ssrn.1638932

Contact Information

Philippe Bacchetta (Contact Author)
University of Lausanne ( email )
Faculty of Business and Economics
Internef 523
1015 Lausanne
Switzerland
HOME PAGE: http://www.hec.unil.ch/pbacchetta/
Swiss Finance Institute ( email )
c/o University of Geneve
40, Bd du Pont-d'Arve
1211 Geneva, CH-6900
Switzerland

Centre for Economic Policy Research (CEPR)
77 Bastwick Street
London, EC1V 3PZ
United Kingdom
Cedric Tille
Graduate Institute of International and Development Studies (HEI) ( email )
PO Box 136
Geneva, CH-1211
Switzerland
HOME PAGE: http://sites.google.com/site/cedrictilleheid/home
Eric Van Wincoop
University of Virginia (UVA) - Department of Economics ( email )
Rouss Hall 114
P.O. Box 400182
Charlottesville, VA 22904-4182
United States
804-924-3997 (Phone)
804-982-2904 (Fax)
National Bureau of Economic Research (NBER)
1050 Massachusetts Avenue
Cambridge, MA 02138
United States
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