Working Paper: CEPR ID: DP7920
Authors: Philippe Bacchetta; Cedric Tille; Eric van Wincoop
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 dynamicmapping 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 Panic; Sunspot-like Equilibria
JEL Codes: E3; F00
Edges that are evidenced by causal inference methods are in orange, and the rest are in light blue.
| Cause | Effect |
|---|---|
| increased perceived risk (D81) | lower asset prices (G19) |
| lower asset prices (G19) | increased perceived risk (D81) |
| current asset price (P) (G19) | risk about tomorrow's asset price (R) (G17) |
| risk about tomorrow's asset price (R) (G17) | current asset price (P) (G19) |
| self-fulfilling shifts in risk (D91) | financial panics (G01) |
| weak fundamentals (E66) | strength of panic (H12) |
| initial small shocks to fundamentals (E32) | gradual increase in perceived risk (D81) |
| gradual increase in perceived risk (D81) | full-blown panic (H12) |
| full-blown panic (H12) | sharp declines in asset prices (G19) |
| full-blown panic (H12) | increased volatility (E32) |
| full-blown panic (H12) | reduced market liquidity (G19) |