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Why does Bad News Increase Volatility and Decrease Leverage?

Ana Fostel and John Geanakoplos ()
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John Geanakoplos: Department of Economics, Yale University

Working Papers from The George Washington University, Institute for International Economic Policy

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)
Date: 2010-06
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Published in Cowles Foundation for Research in Economics Discussion Paper, No. 1762/ the International Monetary Fund September 2010

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http://www.gwu.edu/~iiep/assets/docs/papers/Fostel_IIEPWP2010-18.pdf (application/pdf)

Related works:
Journal Article: Why does bad news increase volatility and decrease leverage? (2012) 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? (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
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