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 are 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 turns 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 gets high, making these extreme fluctuations even worse.
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Bibliographic InfoPaper provided by Cowles Foundation for Research in Economics, Yale University in its series Cowles Foundation Discussion Papers with number 1745R.
Length: 14 pages
Date of creation: Jan 2010
Date of revision: Nov 2011
Publication status: Published in Quantitative Finance (May 2012), 12(5): 695-707
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Other versions of this item:
- Stefan Thurner & J. Doyne Farmer & John Geanakoplos, 2012. "Leverage causes fat tails and clustered volatility," Quantitative Finance, Taylor & Francis Journals, vol. 12(5), pages 695-707, February.
- 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.
- Stefan Thurner & J. Doyne Farmer & John Geanakoplos, 2009. "Leverage Causes Fat Tails and Clustered Volatility," Papers 0908.1555, arXiv.org, revised Jan 2010.
- 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; Trading Volume; Bond Interest Rates
- G14 - Financial Economics - - General Financial Markets - - - Information and Market Efficiency; Event Studies; Insider Trading
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