Risk Appetite and Endogenous Risk

Jean-Pierre Zigrand (), Hyun Song Shin and Jon Danielsson

FMG Discussion Papers from Financial Markets Group

Abstract: 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 closedform 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.

Date: 2010-02
New Economics Papers: this item is included in nep-ban, nep-bec, nep-rmg and nep-upt
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