Cheap Money and Risk Taking: Opacity versus Underlying Risk

Bernhard Eckwert, Burkhard Drees (burkhard.drees.econ@gmail.com) and Felix Vardy

No 2782, EcoMod2011 from EcoMod

Abstract: In a Bayesian setting, investments can be risky either because they are opaque, i.e., their payoff-relevant signals are noisy, or because they are fundamentally risky, i.e., the variance of the prior is high. When interest rates are low (high), investors favor opaque (transparent) projects that are perceived to be fundamentally safe (risky). Therefore, whether low interest rates lead to increased risk taking depends on the sources of risk. Moreover, this analysis helps explain the popularity of senior tranches of CDOs in the pre-crisis years, which were characterized by an unusual combination of high opacity and, supposedly, low fundamental risk. Equilibrium analysis; Modeling information by using the statistical notion of sufficiency; From this concept two different types of risk are derived and their interaction as well as their impact for rational investment and portfolio decisions are analyzed. When interest rates are low (high), investors favor opaque (transparent) projects that are perceived to be fundamentally safe (risky). Therefore, whether low interest rates lead to increased risk taking depends on the sources of risk.

Keywords: Germany; Finance; Modeling: new developments (search for similar items in EconPapers)
Date: 2011-07-06
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Citations: View citations in EconPapers (4)

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