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Why Does Bad News Increase Volatility and Decrease Leverage?

Why Does Bad News Increase Volatility and Decrease Leverage? by Ana Fostel
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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.
International Monetary Fund; September 2010
35 pages; ISBN 9781455237463
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Title: Why Does Bad News Increase Volatility and Decrease Leverage?
Author: Ana Fostel; John Geanakoplos
 
ISBNs
1455237469
9781455204502
9781455205370
9781455237463