Taming Animal Spirits: Risk Management with Behavioural Factors

23 Pages Posted: 12 Apr 2012

See all articles by Mark Davis

Mark Davis

Imperial College London

Sebastien Lleo

NEOMA Business School

Grzegorz Andruszkiewicz

Imperial College London

Date Written: April 11, 2012

Abstract

In several countries a major factor contributing to the current economic crisis was massive borrowing to fund investment projects on the basis of, in retrospect, grossly optimistic valuations. The purpose of this paper is to initiate an approach to project valuation and risk management in which 'behavioural' factors -- Keynes' 'animal spirits' or Greenspan's 'irrational exuberance' -- can be explicitly included. An appropriate framework is risk-neutral valuation based on the use of the numeraire portfolio -- the 'benchmark' approach advocated by Platen and Heath (2006). In the paper, we start by discussing the ingredients of the problem: 'animal spirits', financial instability, market-consistent valuation, the numeraire portfolio and structural models of credit risk. We then study a project finance problem in which a bank lends money to an entrepreneur, collateralized by the value of the latter's investment project. This contains all the components of our approach in a simple setting and illustrates what steps are required. In a final section, we briefly discuss the econometric problems that need to be solved next.

Keywords: collateralized loans, animal spirits, confidence indices, market-consistent valuation, numeraire portfolio, structural credit risk models

JEL Classification: F47, G02, G11, G32

Suggested Citation

Davis, Mark and Lleo, Sebastien and Andruszkiewicz, Grzegorz, Taming Animal Spirits: Risk Management with Behavioural Factors (April 11, 2012). Available at SSRN: https://ssrn.com/abstract=2038327 or http://dx.doi.org/10.2139/ssrn.2038327

Mark Davis (Contact Author)

Imperial College London ( email )

South Kensington Campus
London SW7 2AZ, SW7 2AZ
United Kingdom
02075948486 (Phone)

HOME PAGE: http://www.ma.ic.ac.uk/~mdavis

Sebastien Lleo

NEOMA Business School ( email )

Reims
France

Grzegorz Andruszkiewicz

Imperial College London ( email )

South Kensington Campus
Exhibition Road
London, Greater London SW7 2AZ
United Kingdom

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