A Speculative Asset Pricing Model of Financial Instability

I develop a dynamic equilibrium model that incorporates incorrect beliefs about crash risk and use it to explain the available empirical evidence on financial booms and busts. In the model, if a long period of time goes by without a crash, some investors' perceived crash risk falls below the true crash risk, inducing them to take on excessive leverage. Following a drop in fundamentals, these investors de-lever substantially, both because of their high pre-crash leverage and because they now believe future crashes to be more likely. Together, these two channels generate a crash in the risky asset price that is much larger than the drop in fundamentals. The lower perceived crash risk after years with no crashes also means that the average excess return on the risky asset is low at precisely the moment when any crash that occurs would be especially large in size; moreover, it means that, in the event of a crash, some investors may default and banks may sustain large unexpected losses. Finally, the model shows how pre-crash warning signs can generate financial fragility. By reducing investors' optimism, warning signs also increase investors' uncertainty about their beliefs and thereby make them more likely to overreact to future bad news