Recent crises have seen very large spikes in asset price risk without dramatic shifts
in fundamentals. We propose an explanation for these risk panics based on selfful
lling shifts in risk made possible by a negative link between the current asset
price and risk about the future asset price. This link implies that risk about
tomorrow’s asset price depends on uncertainty about risk tomorrow. This dynamic
mapping of risk into itself gives rise to the possibility of multiple equilibria and
self-ful lling shifts in risk. We show that this can generate risk panics. The impact
of the panic is larger when the shift from a low to a high risk equilibrium takes
place in an environment of weak fundamentals. The sharp increase in risk leads
to a large drop in the asset price, decreased leverage and reduced market liquidity.
We show that the model can account well for the developments during the recent
nancial crisis.
 
(joint with Cedric Tille (Graduate Institute of International and Development Studies) and Eric van Wincoop (University of Virginia))