Dynamic Leveraging–Deleveraging Games

Andreea Minca () and Johannes Wissel ()
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Andreea Minca: School of Operations Research and Information Engineering, Cornell University, Ithaca, New York 14850
Johannes Wissel: School of Operations Research and Information Engineering, Cornell University, Ithaca, New York 14850

Operations Research, 2020, vol. 68, issue 1, 93-114

Abstract: We introduce a new mechanism for leverage dynamics, based on a multiperiod game of lenders with differentiated beliefs about the firm’s fundamental returns. The game features strategic substitutability for low existing leverage and strategic complementarity for high existing leverage. The resulting leverage process exhibits a mean-reverting regime around a long-run level, as long as it stays below an instability level. Above the instability level, leverage becomes explosive. We validate our model empirically using aggregate returns of financial firms over the 10-year period 2001–2010. Our model is consistent with the leveraging/deleveraging of this period and with the 2008 collapse in short-term debt.

Keywords: systemic risk; debt capacity; funding liquidity risk; Nash equilibrium; heterogeneous beliefs (search for similar items in EconPapers)
Date: 2020
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