Why Does Bad News Increase Volatility and Decrease Leverage?

35 Pages Posted: 15 Jul 2010

See all articles by Ana Fostel

Ana Fostel

University of Virginia

John Geanakoplos

Yale University; Santa Fe Institute

Multiple version iconThere are 3 versions of this paper

Date Written: July 14, 2010

Abstract

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.

Keywords: Endogenous leverage, Post-bad news volatility, Post-good news volatility, Volatility smile

JEL Classification: D52, D53, E44, G01, G11, G12

Suggested Citation

Fostel, Ana and Geanakoplos, John D, Why Does Bad News Increase Volatility and Decrease Leverage? (July 14, 2010). Cowles Foundation Discussion Paper No. 1762, Available at SSRN: https://ssrn.com/abstract=1640122 or http://dx.doi.org/10.2139/ssrn.1640122

Ana Fostel

University of Virginia ( email )

1400 University Ave
Charlottesville, VA 22903
United States

John D Geanakoplos (Contact Author)

Yale University ( email )

30 Hillhouse Avenue
New Haven, CT 06511
United States
203-432-3397 (Phone)

HOME PAGE: http://https://economics.yale.edu/people/faculty/john-geanakoplos

Santa Fe Institute ( email )

1399 Hyde Park Road
Santa Fe, NM 87501
United States

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