Leverage causes fat tails and clustered volatility
AbstractWe build a simple model of leveraged asset purchases with margin calls. Investment funds use what is perhaps the most basic financial strategy, called ‘value investing’, i.e. systematically attempting to buy underpriced assets. When funds do not borrow, the price fluctuations of the asset are approximately normally distributed and uncorrelated across time. This changes when the funds are allowed to leverage , i.e. borrow from a bank, which allows them to purchase more assets than their wealth would otherwise permit. During good times, funds that use more leverage have higher profits, increasing their wealth and making them dominant in the market. However, if a downward price fluctuation occurs while one or more funds is fully leveraged, the resulting margin call causes them to sell into an already falling market, amplifying the downward price movement. If the funds hold large positions in the asset, this can cause substantial losses. This in turn leads to clustered volatility: before a crash, when the value funds are dominant, they damp volatility, and after the crash, when they suffer severe losses, volatility is high. This leads to power-law tails, which are both due to the leverage-induced crashes and due to the clustered volatility induced by the wealth dynamics. This is in contrast to previous explanations of fat tails and clustered volatility, which depended on ‘irrational behavior’, such as trend following. A standard (supposedly more sophisticated) risk control policy in which individual banks base leverage limits on volatility causes leverage to rise during periods of low volatility, and to contract more quickly when volatility becomes high, making these extreme fluctuations even worse.
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Bibliographic InfoArticle provided by Taylor and Francis Journals in its journal Quantitative Finance.
Volume (Year): 12 (2012)
Issue (Month): 5 (February)
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Web page: http://taylorandfrancis.metapress.com/link.asp?target=journal&id=111405
Other versions of this item:
- Stefan Thurner & J. Doyne Farmer & John Geanakoplos, 2009. "Leverage Causes Fat Tails and Clustered Volatility," Papers 0908.1555, arXiv.org, revised Jan 2010.
- Stefan Thurner & J. Doyne Farmer & John Geanakoplos, 2010. "Leverage Causes Fat Tails and Clustered Volatility," Cowles Foundation Discussion Papers 1745R, Cowles Foundation for Research in Economics, Yale University, revised Nov 2011.
- Stefan Thurner & J. Doyne Farmer & John Geanakoplos, 2010. "Leverage Causes Fat Tails and Clustered Volatility," Cowles Foundation Discussion Papers 1745, Cowles Foundation for Research in Economics, Yale University.
- E32 - Macroeconomics and Monetary Economics - - Prices, Business Fluctuations, and Cycles - - - Business Fluctuations; Cycles
- E37 - Macroeconomics and Monetary Economics - - Prices, Business Fluctuations, and Cycles - - - Forecasting and Simulation: Models and Applications
- G01 - Financial Economics - - General - - - Financial Crises
- G12 - Financial Economics - - General Financial Markets - - - Asset Pricing
- G14 - Financial Economics - - General Financial Markets - - - Information and Market Efficiency; Event Studies
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