Endogenous risk

[1][2] Risk can be classified into the two categories of exogenous and endogenous.

Exogenous risk is risk stemming from factors outside the financial system, such as political instability, natural disasters, or a pandemic, which may have severe effects on asset prices.

By contrast, endogenous risk is risk stemming from the behaviour of participants within the financial system, such as when positive economic outlooks cause innovation of new financial products, increased leverage, and speculation; these self-reinforcing processes feed on each other to increase risk.

Such endogenous factors, Danielsson and Shin claim, are behind most tail events and severe financial crises.

Shown in the figure on the right, as a financial asset enters into a bubble state, followed by a crash, perceived risk reported by typical risk measures, falls as the bubble builds up, sharply increasing after the bubble deflates.

Actual and perceived risk
A dam is a good illustration of acutal and perceived risk.
Danielsson's dam metaphor: A dam is a good illustration of actual and perceived risk. Before the dam breaks, risk is perceived as low, and we leave the dam as it is. After the dam breaks, risk is perceived as high, and we institute crisis measures. The endogenous or actual risk in the system is the opposite of the perceived risk: when tensions build up before the dam breaks, actual or endogenous risk in the system is high and growing, amplified by self-reinforcing weaknesses. After the dam has broken, actual or endogenous risk in the system is low.