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      Reflexivity in Credit Markets
      07 Jun 2019Working Paper Summaries

      Reflexivity in Credit Markets

      by Robin Greenwood, Samuel G. Hanson, and Lawrence J. Jin
      Investors’ biases and market outcomes affect each other in a two-way feedback loop. This study develops a model of a credit market feedback loop, finding that when investors become more bullish this can predict positive returns in the short run, even if expected returns become more negative at longer horizons.
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      Author Abstract

      Reflexivity is the idea that investors' biased beliefs affect market outcomes, and that market outcomes in turn affect investors' beliefs. We develop a behavioral model of the credit cycle featuring such a two-way feedback loop. In our model, investors form beliefs about firms' creditworthiness, in part by extrapolating past default rates. Investor beliefs influence firms' actual creditworthiness because firms that can refinance maturing debt on favorable terms are less likely to default in the short run—even if fundamentals do not justify investors' generosity. Our model is able to match many features of credit booms and busts, including the imperfect synchronization of credit cycles with the real economy, the negative relationship between past credit growth and the future return on risky bonds, and "calm before the storm" periods in which firm fundamentals have deteriorated but the credit market has not yet turned.

      Paper Information

      • Full Working Paper Text
      • Working Paper Publication Date: April 2019
      • HBS Working Paper Number: NBER Working Paper Series, No. 25747
      • Faculty Unit(s): Finance
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      Robin Greenwood
      Robin Greenwood
      George Gund Professor of Finance and Banking
      Unit Head, Finance
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      Samuel G. Hanson
      Samuel G. Hanson
      Professor of Business Administration
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