COWLES FOUNDATION FOR RESEARCH IN
ECONOMICS Box 208281
COWLES FOUNDATION DISCUSSION PAPER NO. 1762RR Why Does Bad News Increase Volatility and Decrease Leverage? Ana Fostel and John Geanakoplos July 2010 A recent literature shows how an increase in volatility reduces
leverage. However, in order to explain pro-cyclical leverage it assumes that bad
news increases volatility, that is, it assumes an inverse relationship between first and
second moments of asset returns. 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 more volatile in bad times. Agents choose these technologies
because they can be leveraged more during normal times. Together with the existing
literature this explains pro-cyclical leverage. The result also gives a rationale to the
pattern of volatility smiles observed in 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. |
