Why Does Bad News Increase Volatility and Decrease Leverage?

Ana Fostel and John Geanakoplos

No 2010/206, 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: WP; down payment; marginal utility; strike price (search for similar items in EconPapers)
Pages: 35
Date: 2010-09-01
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Citations: View citations in EconPapers (7)

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