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 1762RR, Cowles Foundation Discussion Papers from Cowles Foundation for Research in Economics, Yale University

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)
Pages: 47 pages
Date: 2010-07, Revised 2011-08
New Economics Papers: this item is included in nep-bec
Note: CFP 1354
References: View references in EconPapers View complete reference list from CitEc
Citations: View citations in EconPapers (1)

Published in Journal of Economic Theory (March 2012) 147(2): 501-525

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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? (2010)
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