Self-Fulfilling Risk Panics

Recent crises have seen very large spikes in asset price risk without dramatic shiftsin fundamentals. We propose an explanation for these risk panics based on selffullling shifts in risk made possible by a negative link between the current assetprice and risk about the future asset price. This link implies that risk abouttomorrow’s asset price depends on uncertainty about risk tomorrow. This dynamicmapping of risk into itself gives rise to the possibility of multiple equilibria andself-fullling shifts in risk. We show that this can generate risk panics. The impactof the panic is larger when the shift from a low to a high risk equilibrium takesplace in an environment of weak fundamentals.[...]