Liquidity Provision, Ambiguous Asset Returns and the Financial Crisis

For an economy with dysfunctional intertemporal financial markets the financial sector is modelled as a competitive banking sector oering deposit contracts. In a setting similar to Allen and Gale (1998) properties of the optimal liquidity provision are analyzed for illiquid assets with ambiguous returns. In the context of the model, ambiguity | i.e. incalculable risk | leads to dynamically inconsistent investor behaviour. If the financial sector fails to recognize the presence of ambiguity, unanticipated fundamental crises may occur, which are incorrectly blamed on investors 'loosing their nerves' and 'panicing'. The basic mechanism of the current financial crisis resembles a banking panic in the presence of ambiguous asset returns. The combination of providing additional liquidity and supporting distressed financial institutions implements the regulatory policy suggested by the model. A credible commitment to such 'bail-out policy' does not create a moral hazard problem. Rather, it implements the second best efficient outcome by discouraging excessive caution. Reducing ambiguity by increasing stability, transparency and predictability | as suggested by ordo-liberalism and the 'Freiburger Schule’ | enhances ex-ante welfare.Financial Intermediation, Liquidity, Ambiguity, Choquet Expected Utility, Financial Crisis

Herding and Bank Runs

Traditional models of bank runs do not allow for herding effects, because in these models withdrawal decisions are assumed to be made simultaneously. I extend the banking model to allow a depositor to choose his withdrawal time. When he withdraws depends on his liquidity type (patient or impatient), his private, noisy signal about the quality of the bank's portfolio, and the withdrawal histories of the other depositors. In some cases, the optimal banking contract permits herding runs. Some of these "runs" are efficient in that the bank is liquidated before the portfolio worsens. Others are not efficient; these are cases in which the herd is misled.

The Cry Wolf Effect in Evacuation: a Game-Theoretic Approach

In today's terrorism-prone and security-focused world, evacuation emergencies, drills, and false alarms are becoming more and more common. Compliance to an evacuation order made by an authority in case of emergency can play a key role in the outcome of an emergency. In case an evacuee experiences repeated emergency scenarios which may be a false alarm (e.g., an evacuation drill, a false bomb threat, etc.) or an actual threat, the Aesop's cry wolf effect (repeated false alarms decrease order compliance) can severely affect his/her likelihood to evacuate. To analyse this key unsolved issue of evacuation research, a game-theoretic approach is proposed. Game theory is used to explore mutual best responses of an evacuee and an authority. In the proposed model the authority obtains a signal of whether there is a threat or not and decides whether to order an evacuation or not. The evacuee, after receiving an evacuation order, subsequently decides whether to stay or leave based on posterior beliefs that have been updated in response to the authority's action. Best-responses are derived and Sequential equilibrium and Perfect Bayesian Equilibrium are used as solution concepts (refining equilibria with the intuitive criterion). Model results highlight the benefits of announced evacuation drills and suggest that improving the accuracy of threat detection can prevent large inefficiencies associated with the cry wolf effect.Comment: To be published in Physica

Learning to Forget? Contagion and Political Risk in Brazil

We examine whether Brazilian sovereign spreads of over 20 percent in 2002 could be due to contagion from Argentina or to domestic politics, or both. Treating unilateral debt restructuring as a policy variable gives rise to the possibility of self-fulfilling crisis, which can be triggered by contagion. We explore an alternative political-economy explanation of panic in financial markets inspired by Alesina (1987), which stresses exaggerated market fears of an untried Left-wing candidate. To account for the fall of sovereign spreads since the election, we employ a model of Bayesian learning and analyse the effects of contagion and IMF commitments.sovereign spreads, political risk, Bayesian learning, time-consistency

Conspiracy Theories and Evidential Self-Insulation

What are conspiracy theories? And what, if anything, is epistemically wrong with them? I offer an account on which conspiracy theories are a unique way of holding a belief in a conspiracy. Specifically, I take conspiracy theories to be self-insulating beliefs in conspiracies. On this view, conspiracy theorists have their conspiratorial beliefs in a way that is immune to revision by counter-evidence. I argue that conspiracy theories are always irrational. Although conspiracy theories involve an expectation to encounter some seemingly disconfirming evidence (allegedly planted by the conspirators), resistance to all counter- evidence cannot be justified on these grounds

An Axiomatic Model of Non-Bayesian Updating

This paper models an agent in a three-period setting who does not update according to Bayes'Rule, and who is self-aware and anticipates her updating behavior when formulating plans. The agent is rational in the sense that her dynamic behavior is derived from a single stable preference order on a domain of state-contingent menus of acts. A representation theorem generalizes the (dynamic version of) Anscombe-Aumann's theorem so that both the prior and the way in which it is updated are subjective.Bayes' Rule, non-Bayesian updating, asset price volatility, no-trade theorems, agreeing to bet, common knowledge, temptation, self-control, conservatism, representativeness, overconfidence

An Axiomatic Model of Non-Bayesian Updating

This paper models an agent in a three-period setting who does not update according to Bayes'Rule, and who is self-aware and anticipates her updating behavior when formulating plans. The agent is rational in the sense that her dynamic behavior is derived from a single stable preference order on a domain of state-contingent menus of acts. A representation theorem generalizes the (dynamic version of) Anscombe-Aumann's theorem so that both the prior and the way in which it is updated are subjective.Bayes' Rule, non-Bayesian updating, asset price volatility, no-trade theorems, agreeing to bet, common knowledge, temptation, self-control, conservatism, representativeness, overconfidence

Asset pricing under rational learning about rare disasters : [Version 28 Juli 2011]

This paper proposes a new approach for modeling investor fear after rare disasters. The key element is to take into account that investors’ information about fundamentals driving rare downward jumps in the dividend process is not perfect. Bayesian learning implies that beliefs about the likelihood of rare disasters drop to a much more pessimistic level once a disaster has occurred. Such a shift in beliefs can trigger massive declines in price-dividend ratios. Pessimistic beliefs persist for some time. Thus, belief dynamics are a source of apparent excess volatility relative to a rational expectations benchmark. Due to the low frequency of disasters, even an infinitely-lived investor will remain uncertain about the exact probability. Our analysis is conducted in continuous time and offers closed-form solutions for asset prices. We distinguish between rational and adaptive Bayesian learning. Rational learners account for the possibility of future changes in beliefs in determining their demand for risky assets, while adaptive learners take beliefs as given. Thus, risky assets tend to be lower-valued and price-dividend ratios vary less under adaptive versus rational learning for identical priors. Keywords: beliefs, Bayesian learning, controlled diffusions and jump processes, learning about jumps, adaptive learning, rational learning. JEL classification: D83, G11, C11, D91, E21, D81, C6