Why Does Bad News Increase Volatility and Decrease Leverage?
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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.
Series:
Working Paper No. 2010/206
Subject:
English
Publication Date:
September 1, 2010
ISBN/ISSN:
9781455205370/1018-5941
Stock No:
WPIEA2010206
Pages:
35
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