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Why Does Bad News Increase Volatility and Decrease Leverage?

  • Ana L Fostel
  • John Geanakoplos

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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Paper provided by International Monetary Fund in its series IMF Working Papers with number 10/206.

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Length: 35
Date of creation: 01 Sep 2010
Date of revision:
Handle: RePEc:imf:imfwpa:10/206
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  1. 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.
  2. Nicholas Bloom, 2007. "The Impact of Uncertainty Shocks," NBER Working Papers 13385, National Bureau of Economic Research, Inc.
  3. Shleifer, Andrei & Vishny, Robert W, 1992. " Liquidation Values and Debt Capacity: A Market Equilibrium Approach," Journal of Finance, American Finance Association, vol. 47(4), pages 1343-66, September.
  4. 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.
  5. John Moore & Nobuhiro Kiyotaki, . "Credit Cycles," Discussion Papers 1995-5, Edinburgh School of Economics, University of Edinburgh.
  6. Tobias Adrian & Hyun Song Shin, 2008. "Liquidity and leverage," Staff Reports 328, Federal Reserve Bank of New York.
  7. 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.
  8. Ana Fostel & John Geanakoplos, 2011. "Endogenous Leverage: VaR and Beyond," Cowles Foundation Discussion Papers 1800, Cowles Foundation for Research in Economics, Yale University.
  9. Brunnermeier, Markus K & Pedersen, Lasse Heje, 2007. "Market Liquidity and Funding Liquidity," CEPR Discussion Papers 6179, C.E.P.R. Discussion Papers.
  10. John Geanakoplos, 2010. "The Leverage Cycle," NBER Chapters, in: NBER Macroeconomics Annual 2009, Volume 24, pages 1-65 National Bureau of Economic Research, Inc.
  11. 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.
  12. Hentschel, Ludger & Campbell, John, 1992. "No News is Good News: An Asymmetric Model of Changing Volatility in Stock Returns," Scholarly Articles 3220232, Harvard University Department of Economics.
  13. John Geanakoplos, 2009. "The Leverage Cycle," Cowles Foundation Discussion Papers 1715R, Cowles Foundation for Research in Economics, Yale University, revised Jan 2010.
  14. Gromb, Denis & Vayanos, Dimitri, 2002. "Equilibrium and welfare in markets with financially constrained arbitrageurs," Journal of Financial Economics, Elsevier, vol. 66(2-3), pages 361-407.
  15. John Geanakoplos & Ana Fostel, 2008. "Leverage Cycles and the Anxious Economy," American Economic Review, American Economic Association, vol. 98(4), pages 1211-44, September.
  16. Rubinstein, Mark, 1994. " Implied Binomial Trees," Journal of Finance, American Finance Association, vol. 49(3), pages 771-818, July.
  17. Holmström, Bengt & Tirole, Jean, 1994. "Financial Intermediation, Loanable Funds and the Real Sector," IDEI Working Papers 40, Institut d'Économie Industrielle (IDEI), Toulouse.
  18. Bernanke, Ben S. & Gertler, Mark & Gilchrist, Simon, 1999. "The financial accelerator in a quantitative business cycle framework," Handbook of Macroeconomics, in: J. B. Taylor & M. Woodford (ed.), Handbook of Macroeconomics, edition 1, volume 1, chapter 21, pages 1341-1393 Elsevier.
  19. 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.
  20. Mark Rubinstein., 1994. "Implied Binomial Trees," Research Program in Finance Working Papers RPF-232, University of California at Berkeley.
  21. Araújo, Aloísio & Kubler, Felix & Schommer, Susan, 2012. "Regulating collateral-requirements when markets are incomplete," Journal of Economic Theory, Elsevier, vol. 147(2), pages 450-476.
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