Leverage Causes Fat Tails and Clustered Volatility

Stefan Thurner, J. Farmer and John Geanakoplos ()
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John Geanakoplos: Cowles Foundation, Yale University, https://economics.yale.edu/people/faculty/john-geanakoplos

No 1745R, Cowles Foundation Discussion Papers from Cowles Foundation for Research in Economics, Yale University

Abstract: We build a simple model of leveraged asset purchases with margin calls. Investment funds use what is perhaps the most basic financial strategy, called "value investing," i.e., systematically attempting to buy underpriced assets. When funds do not borrow, the price fluctuations of the asset are approximately normally distributed and uncorrelated across time. This changes when the funds are allowed to leverage, i.e., borrow from a bank, which allows them to purchase more assets than their wealth would otherwise permit. During good times funds that use more leverage have higher profits, increasing their wealth and making them dominant in the market. However, if a downward price fluctuation occurs while one or more funds are fully leveraged, the resulting margin call causes them to sell into an already falling market, amplifying the downward price movement. If the funds hold large positions in the asset this can cause substantial losses. This in turns leads to clustered volatility: Before a crash, when the value funds are dominant, they damp volatility, and after the crash, when they suffer severe losses, volatility is high. This leads to power law tails which are both due to the leverage-induced crashes and due to the clustered volatility induced by the wealth dynamics. This is in contrast to previous explanations of fat tails and clustered volatility, which depended on "irrational behavior," such as trend following. A standard (supposedly more sophisticated) risk control policy in which individual banks base leverage limits on volatility causes leverage to rise during periods of low volatility, and to contract more quickly when volatility gets high, making these extreme fluctuations even worse.

Keywords: Systemic risk; Clustered volatility; Fat tails; Crash; Margin calls; Leverage (search for similar items in EconPapers)
JEL-codes: E32 E37 G01 G12 G14 (search for similar items in EconPapers)
Pages: 14 pages
Date: 2010-01, Revised 2011-11
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Citations: View citations in EconPapers (3)

Published in Quantitative Finance (May 2012), 12(5): 695-707

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Related works:
Journal Article: Leverage causes fat tails and clustered volatility (2012)
Working Paper: Leverage Causes Fat Tails and Clustered Volatility (2010)
Working Paper: Leverage Causes Fat Tails and Clustered Volatility (2010)
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