Events

Finance Seminar

Authors:

• Bernhard Eckwert
  Bielefeld University

• Felix Várdy
  Haas School of Business, UC Berkeley, and IMF

• Burkhard Drees
  International Monetary Fund and Joint Vienna Institute

In a Bayesian setting, investments can be risky either because they are opaque-i.e., their payoff-relevant signals are noisy-or because they are fundamentally risky-i.e., the variance of the prior is high. While both types of risk contribute symmetrically to the overall riskiness of an investment project, we show that changes in interest rates affect risk taking in these two types of risk very differently: When interest rates are high, investors choose transparent projects that are fundamentally risky; when interest rates are low, they choose opaque projects that are fundamentally safe. This analysis may help explain the popularity of senior tranches of CDOs in the low interest rate environment of the pre-crisis years, as these instruments were characterized by an unusual combination of high opacity and, supposedly, low fundamental risk.