Risk-Taking Channel of Monetary Policy:

A Global Game Approach

Stephen Morris
Princeton University
Hyun Song Shin
Princeton University
January 25, 2014
Abstract
We explore a global game model of the impact of monetary policy shocks. Risk-neutral
asset managers interact with risk-averse households in a market with a risky bond and a
oating rate money market fund. Asset managers are averse to coming last in the ranking
of short-term performance. This friction injects a coordination element in asset managers
portfolio choice that leads to large jumps in risk premiums to small future anticipated
changes in central bank policy rates. The si!e of the asset management sector is the key
parameter determining the extent of market disruption to monetary policy shocks.

"irst version. #omments are most welcome.

1
1 Introduction
Monetary policy announcements sometimes exert an apparently disproportionate impact on
maret interest rates! "he #taper tantrum$ in the summer o% 201& is an example o% such
an episode, 'hen maret interest rates (umped %ollo'ing remars )y the *ed +hairman, ,en
,ernane, on the eventual #tapering$ o% the pace o% asset purchases )y the *ederal -eserve!
"he taper tantrum o% 201& is )ut a recent case o% the general phenomenon in 'hich monetary
policy shocs are associated 'ith changes in the ris premium inherent in maret prices, over and
a)ove any change in the actuarially %air long term interest rate implied )y the expectations theory
o% the yield curve! Shiller, +amp)ell and Schoenholt. /101&2 document the early evidence!
Hanson and Stein /20122 and 3ertler and 4aradi /201&2 add to the accumulated evidence that
monetary policy appears to operate through changes in the ris premium inherent in asset prices,
in addition to change in the actuarially %air long5term rate!
"he %act that the ris premium 6uctuates so much opens up a gap )et'een the theory and
practice o% monetary policy! 7iscussions o% central )an communication o%ten treat the maret
as i% it 'ere an individual 'ith )elie%s! "ransparency over the path o% %uture policy rates is seen
as a device to guide long term rates, and crucially, such guidance is seen as something amena)le
to 8ne5tuning! "he term #maret expectations$ is o%ten used in connection 'ith central )an
guidance! 9lthough such a term can serve as a shorthand, it creates the temptation to treat
the #maret$ as a person 'ith coherent )elie%s! "he temptation is to anthropomorphi.e the
maret, and endo' it 'ith attri)utes that it does not have /Shin /201&22!
Ho'ever, the #maret$ is not a person! Maret prices are outcomes o% the interaction o%
many actors, and not the )elie%s o% any one actor! :ven i% prices are the average o% individual
expectations, average expectations %ail even the )asic property o% the la' o% iterated expecta5
tions! ;n other 'ords, the average expectation today o% the average expectation tomorro' o%
some varia)le is not the average expectation today o% that varia)le /9llen, Morris and Shin
/200<22!
;n this paper, 'e explore a glo)al game model o% the transmission o% monetary policy 'ith
2
heterogenous maret participants! =ur model has the %eature that monetary policy exerts a
direct impact on ris premiums through the ris5taing )ehavior o% maret participants!
;n our model, ris5netural investors, interpreted as asset managers, interact 'ith ris5averse
households in a maret %or a risy )ond! 9lthough the asset managers are motivated )y long5
term %undamental asset values, there is an element o% short5termism generated )y the aversion
to coming last in short5term per%ormance ranings among asset managers! >e interpret the
%riction as the loss o% customer mandates o% the asset managers, consistent 'ith the empirical
evidence on the sensitivity o% %und 6o's to %und per%ormance! "hus, the #%riction$ in the model
is that relative per%ormance matters %or %und managers!
"he importance o% relative raning in(ects spillover e?ects across asset managers and an
endogenous coordination element in their port%olio choice! "he cost o% coming last generates
)ehavior that has the out'ard appearance o% shi%ts in pre%erences! Just as in a game o% musical
chairs, 'hen others try harder to gra) a chair, the more e?ort must )e expended to gra) a
chair onesel%! "he ensuing scram)le %or the relatively sa%er option o% selling the risy )ond
in %avor o% the short5term asset leads to a (ump in the yield o% the risy )ond that has the
out'ard appearance o% a sudden (ump in the ris aversion o% the #maret$! "he glo)al game
approach permits the solution o% the trigger level o% the 6oating interest rate 'hen the scram)le
ics in! "hus, 'hen the central )an signals higher %uture rates, the impact on asset prices is
o%ten a)rupt as the ris5taing )ehavior o% maret participants undergoes discrete shi%ts! >e
du) this channel o% the transmission o% monetary policy the #ris5taing channel$ o% monetary
policy, %ollo'ing ,orio and @hu /20002 'ho 8rst coined the term!
"he ey parameter %or the strength o% the ris5taing channel is the si.e o% the asset manage5
ment sector! Auantities thus matter! >hen the sector is large relative to ris5averse households,
ris premiums can )e driven very lo' )y signalling lo' %uture policy rates! ;n return, ho'ever,
the central )an must accept a narro'er region o% %undamentals 'hen ris premiums can )e
ept lo', and a larger (ump in ris premiums 'hen the policy stance changes!
=ur results hold several implications %or the conduct o% monetary policy, )ut 'e postpone
discussion o% the implications until Section 4! >e 8rst present the model and the solution!
&
Model
"here are t'o groups o% investors! *irst, there is a continuum o% ris5neutral investors inter5
preted as asset managers! 9sset managers are indexed )y the unit interval B0, 1C! "hey are
re'arded 'ith a constant %raction o% the terminal value o% their port%olio holding and consume
once only at the terminal date! 9sset managers do not discount the %uture!
9lthough asset managers care a)out long5term asset values, they su?er %rom #last5place
aversion$ in that they are su)(ect to a penalty /to )e descri)ed )elo'2 i% they are raned last
in the value o% their short5term port%olio! >e interpret this penalty as the loss o% customers
su?ered )y the asset manager, as re6ected in the empirical evidence on the positive relationship
)et'een %und 6o's and %und per%ormance!
"he second group o% investors are ris5averse household investors! "hey do not discount the
%uture, they consume once only at the terminal date, and )ehave competitively!
9ll investors %orm port%olios )et'een t'o types o% assets 5 a long5term asset and a short5term
asset! "he long5term asset is a risy .ero coupon )ond that pays only at the terminal date,
)ut the payo? is risy! "he expected payo? at the teriminal date is v 'ith variance
2
! "here
is an outstanding amount o% S units o% the risy )ond!
"he short5term asset is a 6oating rate money maret %und or )an account, and is supplied
elastically! "here is uncertainty over the interest rate ruling over the next interval o% time, )ut
investors have precise signals o% the interest rate! Ho'ever, the interest rate is not common
no'ledge )et'een investors! "he in%ormation structure 'ill )e descri)ed more %ormally )elo'!
!1 "enchmark Three Period Model
>e 8rst examine the )enchmar version o% our model 'here has three dates, 0, 1 and 2! "he
timeline is depicted in *igure 1!
9t date 1, asset managers choose ho' much o% the risy )ond to hold! :ach have one unit
o% 'ealth, 'hich they can allocate )et'een the risy )ond and the 6oating rate account! 9sset
managers cannot )orro' and cannot tae short positions!
4
Trading date
common knowledge;
known but not
common knowledge;
Switching strategy
around threshold
realized;
Consumption
takes place
realized
"igure $. Time line for three period model
"he reali.ed value o% the risy )ond is uncertain, 'ith expected value v! ;nvestors can earn
interest rate 1 D r in the 6oating rate money maret account )et'een date 1 and date 2! "he
price o% the risy )ond p is determined )y maret clearning!
Households have mean5variance pre%erences, and at date 1, they su)mit a competitive de5
mand curve %or the risy )ond! Household h has utility %unctionE
U
h
F vy
1
2
h
y
2

2
D /e py2 /12
'here y is the risy )ond holding o% the household, e is the endo'ment and is ris tolerance!
>e assume that the endo'ment e is large enough that the 8rst5order condition determines
the optimal port%olio! *rom the 8rst5order condition 'ith respect to y and summing across
households, the aggregate demand %or the risy )ond %or the household sector is
p F v

2

h

h
y
F v cy /22
'here c is the positive constant de8ned as c F
2
/

h

h
, and

h

h
is the aggregate ris
tolerance %or the household sector as a 'hole! *igure 2 sho's the determination o% the price p
5
"igure %. Market clearing of the long asset. The price of the long asset at date $ is p. Asset managers
hold A units and households hold S A units.
o% the risy )ond %rom maret clearing! 9sset managers hold A units o% the )ond, 'here A is
exogenous %or no'! Households hold the remainder S A! "he price p and the resulting ris
premium v/p clears the maret )y re'arding households %or )earing ris!
9lthough asset managers consume once at the terminal date /date 22, they su?er %rom last
place aversion!
1
>e assume that there is a penalty su?ered )y any asset manager 'hose port%olio
value is raned last at date 1! "he penalty is in the %orm o% a decline in the asset managerGs
%unds under management, interpreted as 'ithdra'als )y their customers!
;n particular, i% any asset manager is raned last /or eHual last2 at date 1, and proportion x
o% asset managers has a strictly higher port%olio values, then the asset managerGs %unds under
management declines )y a %actor o% x, 'here is a positive constant strictly )et'een 0 and
1! ;n other 'ords, i% the asset manager initially holds 1 dollar o% %unds under management, )ut
comes last, and proportion x o% %und managers has strictly higher port%olio value, then the asset
1
The term &last place aversion' is taken from (uell) et al. *%+$,- who have used the concept in the very
di.erent context of the welfare economics of social deprivation.
<
managerGs %unds under management shrins toE
1 x /&2
9t date 1, asset managers allocate their %unds under management )et'een the risy )ond
and the 6oating rate account! "he asset managers initially start 'ith a holding o% A units o%
the risy )ond! ;% they choose to hold the )ond, each unit o% the )ond yields expected payo?
o% v!
;% the asset manager decides to sell the risy )ond, their sell order is executed simultaneously
'ith the other asset managers 'ho have decided to sell! "he aggregate sale o% the risy security
is matched 'ith the competitive demand curve o% the household investors, and each seller is
matched 'ith household )uyers!
;% proportion x o% the asset managers decide to sell their risy )ond holding, the total supply
o% the risy )ond is xA, and each seller has eHual chance o% placed in the Hueue B0, xC %or order
executiion! "here%ore, i% x asset managers sell the risy )ond, the expected revenue %rom sale
o% one unit is
p
1
2
cx /42
*igure 2 depicts the expected revenue curve p
1
2
cx, 'hose slope is hal% o% the competitive
demand curve p cx!
3iven the last place aversion o% the asset managers, the expected payo? %rom holding the
risy )ond 'hen proportion x sell the risy )ond is
u/x2 F v /1 x2 /52
9lthough the asset manager is ris5neutral and has a long hori.on, the short5term %riction %rom
last place aversion generates element o% short5termism!
;% the asset manager sells the risy )ond at date 1, the proceeds o% the sale are put into the
6oating rate account, 'here it earns interest rate r! Hence, the expected payo? o% the asset
manager %rom selling the risy )ond 'hen proportion x sell is given )y
w/x2 F /1 D r2

p
1
2
cx

/<2
I
"igure ,. /ayo. functions from holding long-dated security and switching to oating rate
*igure & plots the payo?s %rom the t'o strategies as a %unction o% x, the proportion o% asset
managers 'ho sell! "he payo? di?erence u /x2 w/x2 is indicated )y the shaded region!
"he payo? %unctions u/x2 and w/x2 are linear in x, and the payo? di?erence u/x2 w/x2 is
monotonic in x! ;% either u/x2w/x2 is positive %or all x, or negative %or all x, then the pro)lem
is trivial as asset managers have dominant actions! "here%ore, in 'hat %ollo's, 'e %ocus on the
case 'hen u/x2 w/x2 crosses the hori.ontal axis at some point!
! Global Game
"he 6oating rate r ruling )et'een date 1 and date 2 is uncertain, )ut investors have good
in%ormation a)out it! 9t date 1, asset manager i o)serves signal
i
o% the true interest rate r
given )y

i
F r D s
i
/I2
'here s
i
is a uni%ormly distri)uted noise term, 'ith reali.ation in B, C %or small positive
constant ! "he noise terms {s
i
} are independent across asset managers! >e %urther assume
that the ex ante distri)ution o% r is uni%orm! "he assumption that r and the noise term s
i
are uni%ormly distri)uted is %or expositional simplicity only! "he solution to )e o)tained )elo'
1
holds under general conditions on the ex ante distri)ution o% r and the noise structure /Morris
and Shin /200&, section 222!
,ased on their respective signals, asset managers decide 'hether to hold the risy )ond or
sell it! Since asset managers are ris5neutral, it is 'ithout loss o% generality to consider the
)inary choice o% #hold$ or #sell$! 9 strategy %or an asset manager is a mappingE

i
{Hold, Sell} /12
9 collection o% strategies /one %or each asset manager2 is an equilibrium i% the action prescri)ed
)y iGs strategy maximi.es iGs expected payo? at every reali.ation o% signal
i
given othersG
strategies!
9s the 8rst step in the solution, consider s'itching strategies o% the %orm

Sell i% >

Hold i%

/02
%or some threshold value

! >e 8rst solve %or eHuili)rium in s'itching strategies! >e search

%or threshold point

such that every asset manager using the same s'itching strategy around

! >e appeal to the %ollo'ing result in glo)al games! -ecall that x is our notation %or the
proportion o% investors 'ho sell!
#emma 1 Suppose that investors follow the switching strategy around

. Then, in the limit

as 0, the density of x conditional on

is uniform over the unit interval B0, 1C.

"o mae the discussion in our paper sel%5contained, 'e present the proo% o% Jemma 1! *or
economy o% argument 'e sho' the proo% only %or the case o% uni%ormly distri)uted r and uni%orm
noise! Ho'ever, this result is Huite general, and does not depend on the assumption o% uni%orm
density over r and uni%orm noise /Morris and Shin /200&, Section 222!
"he distri)ution o% x conditional on

can )e derived %rom the ans'er to the %ollo'ing

HuestionE
#My signal is

! >hat is the pro)a)ility that x is less than zK$ /A2

0
"igure 0. 1eriving the subjective distribution over x at switching point

"he ans'er to Huestion /A2 gives the cumulative distri)ution %unction o% x evaluated at z, 'hich
'e denote )y G/z|

2! "he density over x is then o)tained )y di?erentiating G/z|

2! "he
steps to ans'ering Huestion /A2 are illustrated in *igure 4!
>hen the true interest rate is r, the signals {
i
} are distri)uted uni%ormly over the interval
Br , r D C! ;nvestors 'ith signals
i
>

are those 'ho sell! Hence,

x F
r D

2
/102
>hen do 'e have x < zK "his happens 'hen r is lo' enough, so that the area under the
density to the right o%

is sHuee.ed! "here is a value o% r at 'hich x is precisely z! "his is

'hen r F r
0
, 'here
r
0
D

2
F z /112
or
r
0
F

D 2z /122
10