Did the 2007-08 Financial Crisis Change Risk Perception?
School of Finance Working Paper Series
This paper investigates, how the 2007-08 financial crisis has affected the risk perceptions of institutional bond investors. Using a methodology novel to the empirical finance literature, we quantify the impact that changes in risk perception have had on bond spreads over the course of the crisis. The relative contribution of the change in risk perceptions can be measured by decomposing changes in credit spreads of US corporate bonds into the contribution caused by changing risk factors and the contribution caused by changes in the pricing of these factors. We document that the lasting increase in credit spreads caused by the current financial crisis is almost exclusively due to increased risk aversion in bond markets. This enduring increase in perception of equity and liquidity risk, which becomes more important in periods of financial distress, is consistent with changing risk perceptions as predicted by theories of ambiguity aversion or social learning in the case of rare events.
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