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Why does Bad News Increase Volatility and Decrease Leverage?

  • Ana Fostel

    ()

    (Institute for International Economic Policy, George Washington University)

  • John Geanakoplos

    ()

    (Department of Economics, Yale University)

The literature on leverage until now shows how an increase in volatility reduces leverage. However, in order to explain pro-cyclical leverage it assumes that bad news increases volatility. 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 volatile in bad times. Together with the old literature this explains pro-cyclical leverage. The result also gives 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://www.gwu.edu/~iiep/assets/docs/papers/Fostel_IIEPWP2010-18.pdf
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Paper provided by The George Washington University, Institute for International Economic Policy in its series Working Papers with number 2010-18.

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Length: 36 pages
Date of creation: Jun 2010
Date of revision:
Publication status: Published in Cowles Foundation for Research in Economics Discussion Paper, No. 1762/ the International Monetary Fund September 2010
Handle: RePEc:gwi:wpaper:2010-18
Contact details of provider: Web page: http://www.gwu.edu/~iiep/
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  1. Bates, David S., 2000. "Post-'87 crash fears in the S&P 500 futures option market," Journal of Econometrics, Elsevier, vol. 94(1-2), pages 181-238.
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  4. 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.
  5. Ricardo Caballero & Arvind Krishnamurthy, 2000. "International and Domestic Collateral Constraints in a Model of Emerging Market Crises," NBER Working Papers 7971, National Bureau of Economic Research, Inc.
  6. John Y. Campbell & Ludger Hentschel, 1991. "No News is Good News: An Asymmetric Model of Changing Volatility in Stock Returns," NBER Working Papers 3742, National Bureau of Economic Research, Inc.
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  9. 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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  12. Ana Fostel & John Geanakoplos, 2011. "Endogenous Leverage: VaR and Beyond," Cowles Foundation Discussion Papers 1800, Cowles Foundation for Research in Economics, Yale University.
  13. Tobias Adrian & Hyun Song Shin, 2008. "Liquidity and leverage," Staff Reports 328, Federal Reserve Bank of New York.
  14. 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.
  15. John Geanakoplos, 2009. "The Leverage Cycle," Cowles Foundation Discussion Papers 1715R, Cowles Foundation for Research in Economics, Yale University, revised Jan 2010.
  16. Holmstrom, Bengt & Tirole, Jean, 1997. "Financial Intermediation, Loanable Funds, and the Real Sector," The Quarterly Journal of Economics, MIT Press, vol. 112(3), pages 663-91, August.
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  20. 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.
  21. Gromb, Denis & Vayanos, Dimitri, 2001. "Equilibrium and Welfare in Markets with Financially Constrained Arbitrageurs," CEPR Discussion Papers 3049, C.E.P.R. Discussion Papers.
  22. Rubinstein, Mark, 1994. " Implied Binomial Trees," Journal of Finance, American Finance Association, vol. 49(3), pages 771-818, July.
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