IFREE-Sponsored Lecture Series at ESI

Hersh Shefrin, Ph.D.
Nov. 18th, 2011

Systemic Risk and Sentiment

A bubble in housing prices was among the key conditions that led to the financial crisis which erupted in 2008, and whose effects are still with us. One of the most striking findings from experimental economics is that asset markets are prone to bubbles, whereas the same statement does not apply to markets for perishable goods. During a bubble, the price of an asset typically exceeds its fundamental value, with the difference being attributable to what economists call sentiment. How can one measure sentiment in real word asset markets? That is the question to be addressed.

The paper I will be presenting applies behavioral asset pricing theory to estimate sentiment in equity markets during the period 2002-2009. Sentiment has many aspects, and the paper focuses on two of these, excessive optimism (also known as irrational exuberance) and overconfidence (the underestimation of volatility). According to the analysis, excessive optimism and overconfidence were low during the recessions of 2001-2002 and 2007-2009, but increased markedly during the economic expansion between these recessions. Notably, overconfidence was very high during September 2008, when Lehman Brothers declared bankruptcy.

Bio:
Hersh Shefrin is the Mario L. Belotti Professor of Finance at Santa Clara University. His book Beyond Greed and Fear provides a comprehensive approach to behavioral finance, and in 2009 was recognized by J.P. Morgan Chase as one of the top ten books published since 2000. Among Professor Shefrin’s other works are A Behavioral Approach to Asset Pricing, Behavioral Corporate Finance, and Ending the Management Illusion. According to a 2003 article that appeared in the American Economic Review, he is one of the top 15 economic theorists to have influenced empirical work. He received his Ph.D. from the London School of Economics in 1974. He holds an honorary doctorate from the University of Oulu, Finland, and is an honorary guest professor at Central-South University in Changsha, China.

Abstract:
Regulators charged with monitoring systemic risk need to focus on sentiment as well as narrowly defined measures of systemic risk. This chapter describes techniques for jointly monitoring the co-evolution of sentiment and systemic risk. To measure systemic risk, we use Marginal Expected Shortfall. To measure sentiment, we apply a behavioral extension of traditional pricing kernel theory, which we supplement with external proxies. We illustrate the technique by analyzing the dynamics of sentiment before, during, and after the global financial crisis which erupted in September 2008. Using stock and options data for the S&P 500 during the period 2002–2009, our analysis documents the statistical relationship between sentiment and systemic risk.

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