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Why Does Bad News Increase Volatility and Decrease Leverage?

Ana Fostel and John Geanakoplos

No 10/206, IMF Working Papers from International Monetary Fund

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: Financial crisis; Economic models; External shocks; Debt; Asset prices; Business cycles; Incomplete markets; Housing; Housing prices; Price elasticity; Endogenous Leverage, Post-Bad News Volatility, Post-Good News Volatility, Volatility Smile, collateral, bond, bonds, financial contracts, stock options, General Equilibrium and Disequilibrium: General, Financial Markets and the Macroeconomy, General Financial Markets, (search for similar items in EconPapers)
New Economics Papers: this item is included in nep-bec, nep-mac and nep-ure
Date: 2010-09-01
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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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