Self-Fulfilling Risk Panics

47 Pages Posted: 12 Jul 2010 Last revised: 28 Aug 2010

See all articles by Philippe Bacchetta

Philippe Bacchetta

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

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)

Multiple version iconThere are 4 versions of this paper

Date Written: July 2010

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.

Suggested Citation

Bacchetta, Philippe and Tille, Cedric and van Wincoop, Eric, Self-Fulfilling Risk Panics (July 2010). NBER Working Paper No. w16159. Available at SSRN: https://ssrn.com/abstract=1636137

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/

Centre for Economic Policy Research (CEPR)

London
United Kingdom

Swiss Finance Institute

c/o University of Geneva
40, Bd du Pont-d'Arve
CH-1211 Geneva 4
Switzerland

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 - 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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