'Risk Appetite and Endogenous Risk' and 'Endogenous and Systemic Risk'
|Speaker:||Jon Danielsson, LSE|
|Date:||Friday 29 October 2010|
|Location:||Streatham Court 006|
Jon Danielsson from LSE will give a talk based on two papers he has written with Hyun Song Shin and Jean-Pierre Zigrand:
Risk is endogenous. Equilibrium risk is the fixed point of the mapping that takes perceived risk to actual risk. When risk-neutral traders operate under Value-at-Risk constraints, market conditions exhibit signs of fluctuating risk appetite and amplification of shocks through feedback effects. Correlations in returns emerge even when underlying fundamental shocks are independent. We derive a closed-form solution of equilibrium returns, correlation and volatility by solving the fixed point problem in closed form. We apply our results to stochastic volatility and option pricing.
The risks impacting financial markets are attributable (at least in part) to the actions of market participants. In turn, market participants' actions depend on perceived risk. In equilibrium, risk is the fixed point of the mapping from perceived risk to actual risk. When market players believe trouble is ahead, they take actions that bring about realized volatility. That is, market turmoil results because market actors anticipate such turmoil. This is "endogenous risk." A model of endogenous risk enables the study of the endogenous propagation of financial booms and distress. Among other things, we can make precise the notion that market participants appear to become "more risk-averse" in response to deteriorating market outcomes. For economists, preferences and beliefs would normally be considered independent of one another. We discuss modeling of endogenous risk and some of its distinctive features, both theoretical and empirical.