Why Does Bad News Increase Volatility and Decrease Leverage?

Ana Fostel and John Geanakoplos ()
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John Geanakoplos: Cowles Foundation, Yale University, https://economics.yale.edu/people/faculty/john-geanakoplos

No 1762, Cowles Foundation Discussion Papers from Cowles Foundation for Research in Economics, Yale University

Abstract: 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.

Keywords: Endogenous leverage; Post-bad news volatility; Post-good news volatility; Volatility smile (search for similar items in EconPapers)
JEL-codes: D52 D53 E44 G01 G11 G12 (search for similar items in EconPapers)
Pages: 34 pages
Date: 2010-07
New Economics Papers: this item is included in nep-bec
References: View complete reference list from CitEc
Citations: View citations in EconPapers (9)

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Related works:
Journal Article: Why does bad news increase volatility and decrease leverage? (2012)
Working Paper: Why Does Bad News Increase Volatility and Decrease Leverage? (2011)
Working Paper: Why Does Bad News Increase Volatility and Decrease Leverage? (2011)
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