Working Paper: CEPR ID: DP8853
Authors: Philippe Bacchetta; Eric van Wincoop
Abstract: Recent episodes (October 2008, May 2010, August 2011) have witnessed huge spikes in equity price risk (implied volatility). Apart from their large size, several features characterize these risk panics. They are global phenomena, shared among a broad set of countries. There is substantial variation though in the extent to which individual countries are impacted, while the impact bears little relation to financial linkages with the epicenter of the crisis. In addition there is usually not a large shock to fundamentals that sets off these panics. We provide an explanation for these risk panic features in the context of a two-country model that allows for self-fulfilling shifts in risk.
Keywords: contagion; international finance
JEL Codes: F30; G15
Edges that are evidenced by causal inference methods are in orange, and the rest are in light blue.
| Cause | Effect |
|---|---|
| sudden spikes in global risk (F65) | self-fulfilling events (G14) |
| news event highlighting weak fundamental (G14) | increase in perceived risk (D81) |
| increase in perceived risk (D81) | spikes in asset prices (E32) |
| spikes in asset prices (E32) | shifts in beliefs about risk (D81) |
| shifts in beliefs about risk (D81) | sudden spikes in global risk (F65) |
| weak macro fundamental (E66) | global nature of risk panics (F65) |
| lack of correlation between financial linkages and panic effects (F65) | panic coordinated by weak fundamental (E32) |
| news event (G14) | focal point of fear (E71) |
| fundamental hedging properties of assets (G13) | variation in panic impact across countries (F65) |