DP10148 | Collateralisation bubbles when investors disagree about risk

Publication Date

21/09/2014

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Abstract

Survey respondents strongly disagree about return risks and, increasingly, macroeconomic uncertainty. This may have contributed to higher asset prices through increased use of collateralisation, which allows risk-neutral investors to realise perceived gains from trade. Investors with lower risk perceptions buy collateralised loans, whose downside-risk they perceive as small. Investors with higher risk perceptions buy upside-risk through asset purchase and collateralised loan issuance, raising prices. More complex collateralised contracts, like CDOs, can increase prices further. In contrast, with disagreement about mean payoffs, price bubbles arise without collateralisation, which may discipline prices as pessimists demand higher returns on risky loans.