Essays on uncertainty in economics
This thesis consists of four essays about "uncertainty" and how markets deal with it. Uncertainty is about subjective beliefs, and thus it often comes with heterogeneous beliefs that may be present temporarily or even forever. The first essay analyzes the effect of uncertainty, and the associated belief heterogeneity, on financial contracts and asset prices. I assume that optimists have limited wealth and take on leverage in order to take positions in line with their beliefs. To have a significant effect on asset prices, they need to borrow from traders with moderate beliefs using loans collateralized by the asset itself. Since moderate lenders do not value the collateral as much as optimists do, they are reluctant to lend, which provides an endogenous constraint on optimists' ability to leverage and to influence asset prices. I demonstrate that optimism is asymmetrically disciplined by this constraint, in the sense that optimism concerning the likelihood of bad events has no or little effect on asset prices, while optimism concerning the relative likelihood of good events could have significant effects. This result emphasizes that what investors disagree about matters for asset prices, to a greater extent than the level of disagreement. New financial assets are often associated with much uncertainty and belief heterogeneity, especially because they do not have a long track record. While the traditional view of financial innovation emphasizes the risk sharing role of new assets, belief heterogeneity about these assets naturally leads to speculation, which represents a powerful economic force in the opposite direction. The second essay analyzes the effect of financial innovation on the allocation of risks when both the risk sharing and the speculation forces are present. I demonstrate that speculation on new assets is amplified by the hedge-more/bet-more effect: Traders make bets on new assets which they then hedge by taking complementary positions on existing assets, which in turn enables them to place larger bets and take on greater risks. This effect suggests that, as asset markets get more complete, they become more susceptible to speculation and further financial innovation is more likely to be destabilizing. The third essay, joint with Ricardo Caballero, concerns the sources of uncertainty. We present a model in which uncertainty suddenly and endogenously rises in response to an increase in the complexity of the economic environment. In our model, banks normally collect information about their trading partners which assures them of the soundness of these relationships. However, when acute financial distress emerges in parts of the financial network, it is not enough to be informed about these partners, as it also becomes important to learn about the health of their trading partners. As conditions continue to deteriorate, banks must
Alternative title: | Essays on uncertainty in macroeconomics and finance |
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Year of publication: |
2010-10-12
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Authors: | Simsek, Alp |
Other Persons: | Daron Acemoglu and Ricardo Caballero. (contributor) |
Institutions: | Massachusetts Institute of Technology. Dept. of Economics. (contributor) |
Publisher: |
Massachusetts Institute of Technology |
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