Reflexivity in Credit Markets

Abstract

Reflexivity is the idea that investors' biased beliefs affect market outcomes and that market outcomes in turn affect investors' future biases. We develop a dynamic behavioral model of the credit cycle featuring this two-way feedback loop. Investors form beliefs about the likelihood of future defaults by extrapolating past defaults. These beliefs influence a firm's actual creditworthiness because the firm is less likely to default in the short run when it can issue debt on favorable terms. Our model matches many features of the credit cycle, including its imperfect synchronization with the real economy and the "calm before the storm" phenomenon.

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