The propagation of financial extremes

Abstract

What drives extreme economic events? Motivated by recent theory, and events in US subprime markets, we begin to open the black box of extremes. Specifically, we extend standard economic analysis of extreme risk, allowing for dynamics and endogeneity. We explain how endogenous extremes may arise in an economy of individuals who engage in resource transfers. Our model suggests that susceptibility to extremes depends on differences in marginal substitution rates. Using over a century of daily stock price data, we construct empirical probabilities of extremes, and document interesting dynamic behavior. We find evidence that extremes are endogenous. This latter finding raises the possibility that control of extremes is a public good, and that extreme events may be an important market failure for regulators and central banks to correct.