Anxiety and Pro-cyclical Risk Taking with Bayesian Agents

37 Pages Posted: 21 Feb 2015 Last revised: 23 Jan 2019

See all articles by Thomas M. Eisenbach

Thomas M. Eisenbach

Federal Reserve Banks - Federal Reserve Bank of New York

Martin C. Schmalz

University of Oxford - Finance; CEPR; CESifo; European Corporate Governance Institute (ECGI)

Date Written: June 28, 2018

Abstract

We provide a model that can explain empirically relevant variations in confidence and risk taking by combining horizon-dependent risk aversion (“anxiety”) and selective memory in a Bayesian intrapersonal game. In the time series, overconfidence is more prevalent when actual risk levels are high, while underconfidence occurs when risks are low. In the cross section, more anxious agents are more prone to biased confidence and their beliefs fluctuate more. This systematic variation in confidence levels can lead to objectively excessive risk taking by “insiders” with the potential to amplify boom-bust cycles.

Keywords: overconfidence, dynamic inconsistency, biases, deception, risk taking

JEL Classification: C72, D03, D81, D83, G02

Suggested Citation

Eisenbach, Thomas M. and Schmalz, Martin C., Anxiety and Pro-cyclical Risk Taking with Bayesian Agents (June 28, 2018). FRB of New York Staff Report No. 711. Available at SSRN: https://ssrn.com/abstract=2566464 or http://dx.doi.org/10.2139/ssrn.2566464

Thomas M. Eisenbach (Contact Author)

Federal Reserve Banks - Federal Reserve Bank of New York ( email )

33 Liberty Street
New York, NY 10045
United States
212-720-6089 (Phone)

HOME PAGE: http://teisenbach.github.io/

Martin C. Schmalz

University of Oxford - Finance ( email )

United States

CEPR ( email )

London
United Kingdom

CESifo ( email )

Poschinger Str. 5
Munich, DE-81679
Germany

European Corporate Governance Institute (ECGI) ( email )

c/o ECARES ULB CP 114
B-1050 Brussels
Belgium

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