Financial Markets and Risk

Research Focus and Mission

Financial markets are fascinating complex social systems and they play an important role in the well-functioning of modern economies and societies. A major role of financial markets is their allocative function. Scarce resources are supposed to be channelled to their best use. In particular, the allocation of risk has become a major driving force in the evolution of financial markets.

Inhowfar better developed markets and the innovation of ever more complex financial instruments for the transfer of risks contribute to a sustainable improvement of our economies and even societies is certainly not a settled issue. While there is ample evidence that well-developed financial markets foster economic growth, there is also evidence - most notably seen during times of crises - that financial markets tend to be characterized by inherent instabilities. Due to their pivotal point in the economy, financial market breakdowns have the potential to threaten the smooth functioning of the real economy with sensible repercussions on the shape of our societies.

In light of our social responsibility, our research area aims at better understanding the well-functioning of financial markets, in particular with respect to the allocation of risk. A better understanding necessitates answers to essentially at least three distinct questions:

  1. What are the risks involved?
    This question relates to the identification and measurement of the underlying subject.
  2. Who is engaged in the allocation process?
    This second question relates to the people, parties and institutions involved (what are their incentives, how do they behave?)
  3. How does the process takes place?
    The third question relates to the market mechanisms that are at work (how does individual behavior influence aggregate outcomes? what measures, regulations can be taken to channel aggregate outcomes?).

While being distinct questions, they are obviously inherently interlinked.

Reflecting these three important areas, our research agenda is structured around three focuses:

  1. Risk management
  2. Financial institutions and their regulation
  3. Functioning of financial markets

Various research methods have been developed and are available to advance our knowledge about financial markets. Financial economics has gained reputation as being a highly rigorous discipline that makes heavy use of advanced mathematical and statistical tools. Much of the academic discussion is framed in formal model-building to discern important relevant mechansims and interrelations. Predictions from models need to be taken to the data to check back if insights gained from the model are readily applicable to real-world situations. Therefore, financial research inevitably needs empirical support. While theoretical and empirical research has a long-standing history, experimental research has established itself in economic sciences more recently as a promising tool for enlarging our understanding of the behavior of decision-makers and the related impact on market outcomes.

Each of the three reseach methods offer distinct advantages, and our research area is aimed at benefitting from all of them. Therefore, we pursue our research agenda by making deliberate use of:

  1. Formal theory development
  2. Empirical studies
  3. Experiments
  4. Simulation-based approaches