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The impact of risk regulation on price dynamics
Jon Danielsson, Hyun Song Shin and Jean-Pierre Zigrand
Most financial risk regulations assume that asset returns are exogenous, where risk is estimated by historical data. This assumption fails to take into account the feedback effect of trading decisions on prices. We investigate this by means of simulations of a general equilibrium model and compare the result to the case when risks regulations are not present. Prices and liquidity are lower in the presence of risk regulations, while volatility is higher. These effects are especially pronounced during crisis. Far from promoting stability, adoption of risk regulations may have the perverse effect of exacerbating financial instability.