Taming Animal Spirits: Risk Management with Behavioural Factors

Abstract

In several countries a major factor contributing to the current economic crisis was massive borrowing to fund investment projects on the basis of, in retrospect, grossly optimistic valuations. The purpose of this paper is to initiate an approach to project valuation and risk management in which 'behavioural' factors -- Keynes' 'animal spirits' or Greenspan's 'irrational exuberance' -- can be explicitly included. An appropriate framework is risk-neutral valuation based on the use of the numeraire portfolio -- the 'benchmark' approach advocated by Platen and Heath (2006). In the paper, we start by discussing the ingredients of the problem: 'animal spirits', financial instability, market-consistent valuation, the numeraire portfolio and structural models of credit risk. We then study a project finance problem in which a bank lends money to an entrepreneur, collateralized by the value of the latter's investment project. This contains all the components of our approach in a simple setting and illustrates what steps are required. In a final section, we briefly discuss the econometric problems that need to be solved next.