COWLES FOUNDATION FOR RESEARCH IN
ECONOMICS Box 208281
COWLES FOUNDATION DISCUSSION PAPER NO. 1762 Why Does Bad News Increase Volatility and Decrease Leverage? Ana Fostel and John Geanakoplos July 2010 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. |
