Irreverent Economics

A productive July,  another paper, Endogenous and Systemic Risk. Available from the usual place, www.riskresearch.org.

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.