The propagation of financial extremes: an application to subprime market spillovers

Abstract

What drives extreme and rare economic events? Motivated by recent theory, and events in US subprime markets, we begin to open the black box of extremes. Specifically, we build a taxonomy of extremes, then extend standard economic analysis of extreme risk. First, we model the potentially relevant dimensions of dynamics and endogeneity. In characterizing individuals? endogenous propagation of extremes, we relate the latter to public goods. Second, using over a century of daily stock price data, we construct empirical probabilities of extremes. We document that extremes are relatively frequent and persistent. We find evidence that extremes are endogenous, raising the possibility that control of extremes is a public good.