EconPapers    
Economics at your fingertips  
 

Why does bad news increase volatility and decrease leverage?

Ana Fostel and John Geanakoplos

Journal of Economic Theory, 2012, vol. 147, issue 2, 501-525

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 pro-cyclical leverage. The result also gives a rationale to the pattern of volatility smiles observed in 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.

Keywords: Collateral; Endogenous leverage; VaR; Volatility; Volatility smile (search for similar items in EconPapers)
JEL-codes: D52 D53 E44 G01 G11 G12 (search for similar items in EconPapers)
Date: 2012
References: View references in EconPapers View complete reference list from CitEc
Citations View citations in EconPapers (27) Track citations by RSS feed

Downloads: (external link)
http://www.sciencedirect.com/science/article/pii/S002205311100113X
Full text for ScienceDirect subscribers only

Related works:
Working Paper: Why Does Bad News Increase Volatility and Decrease Leverage? (2011) Downloads
Working Paper: Why Does Bad News Increase Volatility and Decrease Leverage? (2011) Downloads
Working Paper: Why Does Bad News Increase Volatility and Decrease Leverage? (2010) Downloads
Working Paper: Why does Bad News Increase Volatility and Decrease Leverage? (2010) Downloads
Working Paper: Why Does Bad News Increase Volatility and Decrease Leverage? (2010) Downloads
This item may be available elsewhere in EconPapers: Search for items with the same title.

Export reference: BibTeX RIS (EndNote, ProCite, RefMan) HTML/Text

Persistent link: https://EconPapers.repec.org/RePEc:eee:jetheo:v:147:y:2012:i:2:p:501-525

Access Statistics for this article

Journal of Economic Theory is currently edited by A. Lizzeri and K. Shell

More articles in Journal of Economic Theory from Elsevier
Series data maintained by Dana Niculescu ().

 
Page updated 2017-12-18
Handle: RePEc:eee:jetheo:v:147:y:2012:i:2:p:501-525