Why Does Bad News Increase Volatility and Decrease Leverage?

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.
Publication date: September 2010
ISBN: 9781455205370
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Finance , Security (National and International) , Endogenous Leverage , Post-Bad News Volatility , Post-Good News Volatility , Volatility Smile , collateral , bond , bonds , financial contracts , stock options , General Equilibrium and Disequilibrium: General , Financial Markets and the Macroeconomy , General Financial Market

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