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Why Does Bad News Increase Volatility and Decrease Leverage?

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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 procyclical leverage. The result also gives a rationale to the pattern of volatility smiles observed in the 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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File URL: http://cowles.econ.yale.edu/P/cd/d17b/d1762-r.pdf
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Bibliographic Info

Paper provided by Cowles Foundation for Research in Economics, Yale University in its series Cowles Foundation Discussion Papers with number 1762R.

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Length: 42 pages
Date of creation: Jul 2010
Date of revision: Jan 2011
Handle: RePEc:cwl:cwldpp:1762r

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

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References

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  1. Nicholas Bloom, 2009. "The Impact of Uncertainty Shocks," Econometrica, Econometric Society, vol. 77(3), pages 623-685, 05.
  2. John Geanakoplos, 2009. "The Leverage Cycle," Cowles Foundation Discussion Papers 1715R, Cowles Foundation for Research in Economics, Yale University, revised Jan 2010.
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  16. Dewatripont,Mathias & Hansen,Lars Peter & Turnovsky,Stephen J. (ed.), 2003. "Advances in Economics and Econometrics," Cambridge Books, Cambridge University Press, number 9780521818728.
  17. Markus K. Brunnermeier & Lasse Heje Pedersen, 2007. "Market Liquidity and Funding Liquidity," NBER Working Papers 12939, National Bureau of Economic Research, Inc.
  18. 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.
  19. John Geanakoplos, 2010. "Solving the Present Crisis and Managing the Leverage Cycle," Cowles Foundation Discussion Papers 1751, Cowles Foundation for Research in Economics, Yale University.
  20. 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.
  21. John Geanakoplos & Ana Fostel, 2008. "Leverage Cycles and the Anxious Economy," American Economic Review, American Economic Association, vol. 98(4), pages 1211-44, September.
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  25. Caballero, Ricardo J. & Krishnamurthy, Arvind, 2001. "International and domestic collateral constraints in a model of emerging market crises," Journal of Monetary Economics, Elsevier, vol. 48(3), pages 513-548, December.
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Citations

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Cited by:
  1. Ana Fostel & John Geanakoplos, 2012. "Tranching, CDS, and Asset Prices: How Financial Innovation Can Cause Bubbles and Crashes," American Economic Journal: Macroeconomics, American Economic Association, vol. 4(1), pages 190-225, January.
  2. Ana Fostel, 2012. "Leverage and Asset Prices: An Experiment," Working Papers 2012-1, The George Washington University, Institute for International Economic Policy.
  3. 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).
  4. 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.
  5. Ana Fostel & John Geanakoplos, 2013. "Financial Innovation, Collateral and Investment," Cowles Foundation Discussion Papers 1903, Cowles Foundation for Research in Economics, Yale University.
  6. Ana Fostel & John Geanakoplos, 2013. "Leverage and Default in Binomial Economies: A Complete Characterization," Levine's Working Paper Archive 786969000000000755, David K. Levine.
  7. Angeloni, Ignazio & Faia, Ester & Lo Duca, Marco, 2013. "Monetary policy and risk taking," SAFE Working Paper Series 8, Research Center SAFE - Sustainable Architecture for Finance in Europe, Goethe University Frankfurt.
  8. Ana Fostel & John Geanakoplos, 2013. "Reviewing the Leverage Cycle," Cowles Foundation Discussion Papers 1918, Cowles Foundation for Research in Economics, Yale University.
  9. Balasko, Yves & Geanakoplos, John, 2012. "Introduction to general equilibrium," Journal of Economic Theory, Elsevier, vol. 147(2), pages 400-406.
  10. Ana Fostel & John Geanakoplos, 2013. "Financial Innovation, Collateral and Investment," Levine's Working Paper Archive 786969000000000750, David K. Levine.
  11. Ambrogio Cesa-Bianchi & M. Hashem Pesaran & Alessandro Rebucci, 2014. "Uncertainty and Economic Activity: A Global Perspective," IDB Publications 86257, Inter-American Development Bank.
  12. 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.).
  13. Ambrogio Cesa-Bianchi & M. Hashem Pesaran & Alessandro Rebucci, 2014. "Uncertainty and Economic Activity: A Global Perspective," CESifo Working Paper Series 4736, CESifo Group Munich.

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