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Ambiguity Attitudes, Leverage Cycle and Asset Prices

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  • Bassanin, Marzio
  • Faia, Ester
  • Patella, Valeria

Abstract

Financial crises often originate in debt markets, where collateral constraints and opacity of asset values generate intrinsic instability. In such ambiguous contexts endogenous beliefs formation plays a crucial role in explaining asset price and leverage cycles. We introduce state-contingent ambiguity attitudes embedding ambiguity aversion and seeking, which endogenously induces pessimism (left-skewed beliefs) in recessions and optimism (rightskewed beliefs) in booms, in a model where borrowers face occasionally binding collateral constraints. We use GMM estimation with latent value functions to estimate the ambiguity attitudes process. By simulating a crisis scenario in our model we show that optimism in booms is responsible for higher asset price and leverage growth and pessimism in recessions is responsible for sharper de-leveraging and asset price bursts. Analytically and numerically (using global methods) we show that our state-contingent ambiguity attitudes coupled with the collateral constraints can explain relevant asset price and debt cycle facts around the unfolding of a financial crisis.

Suggested Citation

  • Bassanin, Marzio & Faia, Ester & Patella, Valeria, 2019. "Ambiguity Attitudes, Leverage Cycle and Asset Prices," CEPR Discussion Papers 13875, C.E.P.R. Discussion Papers.
  • Handle: RePEc:cpr:ceprdp:13875
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    References listed on IDEAS

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    1. Hansen, Lars Peter, 1982. "Large Sample Properties of Generalized Method of Moments Estimators," Econometrica, Econometric Society, vol. 50(4), pages 1029-1054, July.
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    More about this item

    Keywords

    ambiguity attitudes; asset price cycle; kinked multiplier preferences; leverage cycle; occasionally binding constraints;

    JEL classification:

    • E0 - Macroeconomics and Monetary Economics - - General
    • E5 - Macroeconomics and Monetary Economics - - Monetary Policy, Central Banking, and the Supply of Money and Credit
    • G01 - Financial Economics - - General - - - Financial Crises

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