Ambiguity Attitudes, Leverage Cycle and Asset Prices

Ester Faia, Marzio Bassanin and Valeria Patella

No 13875, CEPR Discussion Papers from C.E.P.R. Discussion Papers

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.

Keywords: Ambiguity attitudes; Occasionally binding constraints; Kinked multiplier preferences; Leverage cycle; Asset price cycle (search for similar items in EconPapers)
JEL-codes: E0 E5 G01 (search for similar items in EconPapers)
Date: 2019-07
New Economics Papers: this item is included in nep-mac
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