Bubbles, Financial Crises, and Systemic Risk
, Handbook of the Economics of Finance, Amsterdam, (In Press)
This chapter surveys the literature on bubbles, financial crises, and systemic risk. The first part of the chapter provides a brief historical account of bubbles and financial crisis. The second part of the chapter gives a structured overview of the literature on financial bubbles. The third part of the chapter discusses the literatures on financial crises and systemic risk, with particular emphasis on amplification and propagation mechanisms during financial crises, and the measurement of systemic risk. Finally, we point toward some questions for future research.
Deciphering the Liquidity and Credit Crunch 2007-2008
, Journal of Economic Perspectives, Volume 23, Number 1, p.77-100, (2009)
This paper summarizes and explains the main events of the liquidity and credit crunch in 2007-08. Starting with the trends leading up to the crisis, I explain how these events unfolded and how four different amplification mechanisms magnified losses in the mortgage market into large dislocations and turmoil in financial markets.
Bubbles and Crashes
, Econometrica, Volume 71, Number 1, p.173-204, (2003)
Bubbles persist since each rational arbitrageur does not know when other arbitrageurs will attack.
We present a model in which an asset bubble can persist despite the presence of rational arbitrageurs. The resilience of the bubble stems from the inability of arbitrageurs to temporarily coordinate their selling strategies. This synchronization problem together with the individual incentive to time the market results in the persistence of bubbles over a substantial period. Since the derived trading equilibrium is unique, our model rationalizes the existence of bubbles in a strong sense. The model also provides a natural setting in which news events, by enabling synchronization, can have a disproportionate impact relative to their intrinsic informational content.
Synchronization risk and delayed arbitrage
, Journal of Financial Economics, Volume 66, Number 2-3, p.341-360, (2002)
Models the Wile E. Coyote effect, since synchronization risk leads to market timing by arbitrageurs and delays arbitrage.
We argue that arbitrage is limited if rational traders face uncertainty about when their peers will exploit a common arbitrage opportunity. This synchronization risk—which is distinct from noise trader risk and fundamental risk—arises in our model because arbitrageurs become sequentially aware of mispricing and they incur holding costs. We show that rational arbitrageurs “time the market” rather than correct mispricing right away. This leads to delayed arbitrage. The analysis suggests that behavioral influences on prices are resistant to arbitrage in the short and intermediate run.