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Why does bad news increase volatility and decrease leverage?

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  • Fostel, Ana
  • Geanakoplos, John

Abstract

A recent literature shows how an increase in volatility reduces leverage. However, in order to explain pro-cyclical leverage it assumes that bad news increases volatility, that is, it assumes an inverse relationship between first and second moments of asset returns. This paper suggests a reason why bad news is more often than not associated with higher future volatility. We show that, in a model with endogenous leverage and heterogeneous beliefs, agents have the incentive to invest mostly in technologies that become more volatile in bad times. Agents choose these technologies because they can be leveraged more during normal times. Together with the existing literature this explains pro-cyclical leverage. The result also gives a rationale to the pattern of volatility smiles observed in stock options since 1987. Finally, the paper presents for the first time a dynamic model in which an asset is endogenously traded simultaneously at different margin requirements in equilibrium.

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Bibliographic Info

Article provided by Elsevier in its journal Journal of Economic Theory.

Volume (Year): 147 (2012)
Issue (Month): 2 ()
Pages: 501-525

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Handle: RePEc:eee:jetheo:v:147:y:2012:i:2:p:501-525

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Web page: http://www.elsevier.com/locate/inca/622869

Related research

Keywords: Collateral; Endogenous leverage; VaR; Volatility; Volatility smile;

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References

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  1. Gromb, Denis & Vayanos, Dimitri, 2002. "Equilibrium and welfare in markets with financially constrained arbitrageurs," Journal of Financial Economics, Elsevier, vol. 66(2-3), pages 361-407.
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  5. John Geanakoplos, 2010. "Solving the present crisis and managing the leverage cycle," Economic Policy Review, Federal Reserve Bank of New York, issue Aug, pages 101-131.
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  13. Ana Fostel & John Geanakoplos, 2004. "Collateral Restrictions and Liquidity Under-Supply: A Simple Model," Cowles Foundation Discussion Papers 1468R, Cowles Foundation for Research in Economics, Yale University, revised Aug 2006.
  14. Ana Fostel & John Geanakoplos, 2011. "Endogenous Leverage: VaR and Beyond," Cowles Foundation Discussion Papers 1800, Cowles Foundation for Research in Economics, Yale University.
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Citations

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Cited by:
  1. Ana Fostel & John Geanakoplos, 2011. "Tranching, CDS and Asset Prices: How Financial Innovation Can Cause Bubbles and Crashes," Levine's Working Paper Archive 786969000000000168, David K. Levine.
  2. Ignazio Angeloni, 2010. "Monetary Policy and Risk Taking," Working Papers 380, Bruegel.
  3. Chiara Scotti, 2013. "Surprise and uncertainty indexes: real-time aggregation of real-activity macro surprises," International Finance Discussion Papers 1093, Board of Governors of the Federal Reserve System (U.S.).
  4. Ambrogio Cesa-Bianchi & M. Hashem Pesaran & Alessandro Rebucci, 2014. "Uncertainty and Economic Activity: A Global Perspective," CESifo Working Paper Series 4736, CESifo Group Munich.
  5. Ana Fostel, 2012. "Leverage and Asset Prices: An Experiment," Working Papers 2012-1, The George Washington University, Institute for International Economic Policy.
  6. Ana Fostel & John Geanakoplos, 2012. "Leverage and Default in Binomial Economies: A Complete Characterization," Cowles Foundation Discussion Papers 1877R, Cowles Foundation for Research in Economics, Yale University, revised Jul 2013.
  7. Ana Fostel & John Geanakoplos, 2013. "Leverage and Default in Binomial Economies: A Complete Characterization," Levine's Working Paper Archive 786969000000000755, David K. Levine.
  8. Ana Fostel & John Geanakoplos, 2013. "Financial Innovation, Collateral and Investment," Cowles Foundation Discussion Papers 1903, Cowles Foundation for Research in Economics, Yale University.
  9. Ana Fostel & John Geanakoplos, 2013. "Financial Innovation, Collateral and Investment," Levine's Working Paper Archive 786969000000000750, David K. Levine.
  10. Balasko, Yves & Geanakoplos, John, 2012. "Introduction to general equilibrium," Journal of Economic Theory, Elsevier, vol. 147(2), pages 400-406.
  11. KURASHIMA Daichi & MIZUNAGA Masashi & ODAKI Kazuhiko & WATANABE Wako, 2013. "Is Leverage a Determinant of Asset Price? Evidence from real estate transaction data," Discussion papers 13082, Research Institute of Economy, Trade and Industry (RIETI).
  12. Ana Fostel & John Geanakoplos, 2013. "Reviewing the Leverage Cycle," Cowles Foundation Discussion Papers 1918, Cowles Foundation for Research in Economics, Yale University.

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