What causes financial risk? What causes financial crises? Under mainstream equilibrium theory these questions have a trivial answer. Financial risk is measured in terms of volatility, the size of price fluctuations. If all investors are rational then prices are always set correctly, and changes in prices passively reflect the arrival of new information. The arrival of new information is exogenous, i.e. it is generated outside of financial markets. Markets are merely responding to and interpreting events in the economy without affecting them. A crash is just a big price move, occasioned by the sudden receipt of large negative information.
This can’t be right. The mainstream view of financial risk has come under attack for a variety of reasons. For example, there are patterns in the temporal behavior of volatility that cry out for explanation. SFI’s new research initiative on Financial Risk uses both empirical and theoretical methods to understand the origins of financial risk. This meeting will endeavor to shed new light on what causes financial risk, developing new quantitative theories for market behavior and changing our view of the factors that markets depend on. This event is sponsored by Morgan Stanley.
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