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Innovations, rents and risk


Biais, Bruno; Rochet, Jean-Charles; Woolley, Paul (2010). Innovations, rents and risk. The Paul Woolley Centre Working Paper Series 13 659, University of Zurich.

Abstract

We offer a rational expectations model of the dynamics of innovative industries. The fundamentalvalue of innovations is uncertain and one must learn whether they are solid or fragile. Also, when theindustry is new, it is difficult to monitor managers and make sure they exert the effort necessary toreduce default risk. This gives rise to moral hazard. In this context, initial successes spur optimismand growth. But increasingly confident managers end up requesting large rents. If these becometoo high, investors give up on incentives, and default risk rises. Thus, moral hazard gives rise toendogenous crises and fat tails in the distribution of aggregate default risk. We calibrate our modelto fit the stylized facts of the MBS industry’s boom and bust cycle.2

Abstract

We offer a rational expectations model of the dynamics of innovative industries. The fundamentalvalue of innovations is uncertain and one must learn whether they are solid or fragile. Also, when theindustry is new, it is difficult to monitor managers and make sure they exert the effort necessary toreduce default risk. This gives rise to moral hazard. In this context, initial successes spur optimismand growth. But increasingly confident managers end up requesting large rents. If these becometoo high, investors give up on incentives, and default risk rises. Thus, moral hazard gives rise toendogenous crises and fat tails in the distribution of aggregate default risk. We calibrate our modelto fit the stylized facts of the MBS industry’s boom and bust cycle.2

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Additional indexing

Item Type:Working Paper
Communities & Collections:03 Faculty of Economics > Department of Banking and Finance
Dewey Decimal Classification:330 Economics
Language:English
Date:2010
Deposited On:22 May 2012 07:35
Last Modified:21 Nov 2017 15:43
Series Name:The Paul Woolley Centre Working Paper Series 13
ISSN:0956-8549
Official URL:http://www2.lse.ac.uk/fmg/researchProgrammes/paulWoolleyCentre/WorkingPapers/dp659PWC13.pdf
Other Identification Number:merlin-id:5020

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