Conferences at Department of Economics, University of Toronto, RCEF 2012: Cities, Open Economies, and Public Policy

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Cheap Money and Risk Taking: Opacity versus Fundamental Risk

Bernhard Eckwert

Last modified: 2012-07-12

Abstract


We explore the effect of interest rates on risk taking and find that the direction of the effect depends on the type of risk involved. In a Bayesian setting, investments can be risky either because they are opaque–i.e., their payoff-relevant signals are noisy–or because they are fundamentally risky–i.e., the dispersion of the prior is high. While both types of risk contribute symmetrically to the overall riskiness of an investment project, we show that changes in interest rates affect risk taking in these two types of risk very differently: when interest rates are high, investors choose transparent projects that are fundamentally risky; when interest rates are low, they choose opaque projects that are fundamentally safe. This makes the net effect of interest rates on risk taking necessarily ambiguous and dependent on the sources of risk.

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