Reflexivity in Credit Markets

59 Pages Posted: 15 Apr 2019 Last revised: 7 Nov 2022

See all articles by Robin M. Greenwood

Robin M. Greenwood

Harvard Business School - Finance Unit; National Bureau of Economic Research (NBER)

Samuel Gregory Hanson

Harvard University - Business School (HBS)

Lawrence J. Jin

SC Johnson College of Business, Cornell University

Date Written: April 2019

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

Greenwood, Robin M. and Hanson, Samuel Gregory and Jin, Lawrence J., Reflexivity in Credit Markets (April 2019). NBER Working Paper No. w25747, Available at SSRN: https://ssrn.com/abstract=3372051

Robin M. Greenwood (Contact Author)

Harvard Business School - Finance Unit ( email )

Boston, MA 02163
United States
617-495-6979 (Phone)

National Bureau of Economic Research (NBER)

1050 Massachusetts Avenue
Cambridge, MA 02138
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Samuel Gregory Hanson

Harvard University - Business School (HBS) ( email )

Soldiers Field Road
Morgan 270C
Boston, MA 02163
United States

Lawrence J. Jin

SC Johnson College of Business, Cornell University ( email )

310E Warren Hall
Ithaca, NY 14850
United States
607-255-0581 (Phone)

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