Working Paper: NBER ID: w25747
Authors: Robin Greenwood; Samuel G. Hanson; Lawrence J. Jin
Abstract: Reflexivity is the idea that investors’ biased beliefs affect market outcomes and that market outcomes in turn affect investors’ future biases. We develop a dynamic behavioral model of the credit cycle featuring this two-way feedback loop. Investors form beliefs about the likelihood of future defaults by extrapolating past defaults. Investor beliefs influence a firm’s actual creditworthiness because the firm is less likely to default in the short run when it can issue debt on favorable terms. Our model matches many features of the credit cycle, including its imperfect synchronization with the real economy and the “calm before the storm” phenomenon.
Keywords: credit markets; investor sentiment; financial crises; behavioral finance
JEL Codes: G01; G40
Edges that are evidenced by causal inference methods are in orange, and the rest are in light blue.
| Cause | Effect |
|---|---|
| biased investor beliefs (G41) | credit market dynamics (E44) |
| investor beliefs about future defaults (G33) | perceived default probabilities (G33) |
| perceived default probabilities (G33) | credit spreads (G12) |
| credit spreads (G12) | firm leverage (G32) |
| investor sentiment (G41) | debt issuance (H63) |
| debt issuance (H63) | default risk (G33) |
| defaults (Y60) | perceived default probabilities (G33) |
| perceived default probabilities (G33) | costs of debt issuance (H74) |
| costs of debt issuance (H74) | default spiral (Y20) |