Pay Attention or Pay Extra: Evidence on the Compensation of Investors for the Implicit Credit Risk of Structured Products

Arnold, Marc; Schuette, Dustin

doi:10.2139/ssrn.2419016

“…(), Barberis and Shleifer (), Greenwood and Shleifer (), Barberis et al. (, ), Gennaioli, Ma, and Shleifer ()) and the neglect of risk (Gennaioli, Shleifer, and Vishny (), Coval, Pan, and Stafford (), Arnold, Schuette, and Wagner ()). Critically, under diagnostic expectations, departures from the rational benchmark are driven by updates in the probability of future events, and thus depend on the true distribution of states of nature.…”

mentioning

confidence: 99%

Diagnostic Expectations and Credit Cycles

Bordalo¹,

Gennaioli²,

Shleifer

³

2018

The Journal of Finance

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We present a model of credit cycles arising from diagnostic expectations-a belief formation mechanism based on Kahneman and Tversky's representativeness heuristic. Diagnostic expectations overweight future outcomes that become more likely in light of incoming data. The expectations formation rule is forward looking and depends on the underlying stochastic process, and thus is immune to the Lucas critique. Diagnostic expectations reconcile extrapolation and neglect of risk in a unified framework. In our model, credit spreads are excessively volatile, overreact to news, and are subject to predictable reversals. These dynamics can account for several features of credit cycles and macroeconomic volatility.

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“…It implies that in a boom investors are excessively optimistic and systematically become more pessimistic in the future, leading to a crisis even without deteriorating fundamentals. The model unifies the phenomena of extrapolation (Cagan 1956, Cutler et al 1990, DeLong et al 1990, Barberis and Shleifer 2003, Greenwood and Shleifer 2014, Barberis et al 2015a, b, Gennaioli, Ma, and Shleifer 2015 and the neglect of risk (Gennaioli, Shleifer, and Vishny 2012, Coval, Pan, and Stafford 2014, Arnold, Schuette, and Wagner 2015. Critically, households in our model are forward looking, and recognize policy shifts.…”

Section: Introductionmentioning

confidence: 91%

Diagnostic Expectations and Credit Cycles

Bordalo¹,

Gennaioli²,

Shleifer³

2016

View full text Add to dashboard Cite

We present a model of credit cycles arising from diagnostic expectations -a belief formation mechanism based on Kahneman and Tversky's (1972) representativeness heuristic. In this formulation, when forming their beliefs agents overweight future outcomes that have become more likely in light of incoming data. The model reconciles extrapolation and neglect of risk in a unified framework. Diagnostic expectations are forward looking, and as such are immune to the Lucas critique and nest rational expectations as a special case. In our model of credit cycles, credit spreads are excessively volatile, over-react to news, and are subject to predictable reversals. These dynamics can account for several features of credit cycles and macroeconomic volatility.

show abstract

“…It implies that in a boom investors are excessively optimistic and systematically become more pessimistic in the future, leading to a crisis even without deteriorating fundamentals. The model unifies the phenomena of extrapolation (Cagan 1956, Cutler et al 1990, DeLong et al 1990, Barberis and Shleifer 2003, Greenwood and Shleifer 2014, Barberis et al 2015a, b, Gennaioli, Ma, and Shleifer 2015 and the neglect of risk (Gennaioli, Shleifer, and Vishny 2012, Coval, Pan, and Stafford 2014, Arnold, Schuette, and Wagner 2015. Critically, households in our model are forward looking, and recognize policy shifts.…”

Section: Introductionmentioning

confidence: 91%