Why Does Bad News Increase Volatility and Decrease Leverage?

September 1, 2010

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Format: Chicago

Ana L Fostel, and John Geanakoplos. Why Does Bad News Increase Volatility and Decrease Leverage?, (USA: International Monetary Fund, 2010) accessed September 19, 2024

Disclaimer: This Working Paper should not be reported as representing the views of the IMF.The views expressed in this Working Paper are those of the author(s) and do not necessarily represent those of the IMF or IMF policy. Working Papers describe research in progress by the author(s) and are published to elicit comments and to further debate

Summary

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.

Subject: Asset prices, Bonds, Collateral, Consumption, Securities

Keywords: Down payment, Marginal utility, Strike price, WP

Publication Details

Pages:

35
Volume:

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DOI:

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Issue:

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Series:

Working Paper No. 2010/206
Stock No:

WPIEA2010206
ISBN:

9781455205370
ISSN:

1018-5941

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