A behavioral macroeconomic model with endogenous boom-bust cycles and leverage dynamcis

We merge a financial market model with leverage-constrained, heterogeneous agents with a reduced-form version of the New-Keynesian standard model. Agents in both submodels are assumed to be boundedly rational. The fi nancial market model produces endogenously arising boom-bust cycles. It is also capable to generate highly non-linear deleveraging processes, fi re sales and ultimately a default scenario. Asset price booms are triggered via self-fulfilling prophecies. Asset price busts are induced by agents' choice of an increasingly fragile balance sheet structure during good times. Their vulnerability is inevitably revealed by small, randomly occurring shocks. Our transmission channel of financial market activity to the real sector embraces a recent strand of literature shedding light on the link between the active balance sheet management of financial market participants, the induced procyclical fluctuations of desired risk compensations and their final impact on the real economy. We show that a systematic central bank reaction on financial market developments dampens macroeconomic volatility considerably. Furthermore, restricting leverage in a countercyclical fashion limits the magnitude of financial cycles and hence their impact on the real economy. --behavioral economics,New-Keynesian macroeconomics,monetary policy,agent-based financial market model,leverage,macroprudential regulation,financial stability,asset price bubbles,systemic risk

U.S. Energy Futures Markets: Liquidity and Optimal Speculative Position Limits

U.S. energy prices have grown dramatically since the 2007 financial crisis. Speculators are blamed for market manipulation, and regulators seek additional tools to control the market. Given the growing roles of liquidity and position limits in finance along with recent Wall Street legislation changes made by the Dodd-Frank Act, we carry out studies to test how effectively price impact liquidity measures measure liquidity, whether position limits have impacts on market liquidity, and how optimal speculative position limits should be modeled, based on microstructure theories. Using the major New York Mercantile Exchange (NYMEX) energy futures data from Bloomberg, we compare low-frequency liquidity proxies with high-frequency liquidity benchmarks, run an event study on futures contracts’ liquidity following the launching of the Dodd-Frank Act, and develop a theory-based position limits model. Our empirical results indicate that the new price impact liquidity proxy developed in this thesis is more effective in measuring liquidity than the Amihud (2002) proxy. Further, contrary to Grossman's (1993) finding, position limits on financial futures do not force traders to move to foreign substitute markets. Finally, position limits for single commodity derivatives should be based on corresponding underlying spot market factors, and strong fluctuations in optimal position limits over time suggest that exchanges should update position limits on a high-frequency basis

The dynamics of the leverage cycle

We present a simple agent-based model of a financial system composed of leveraged investors such as banks that invest in stocks and manage their risk using a Value-at-Risk constraint, based on historical observations of asset prices. The Value-at-Risk constraint implies that when perceived risk is low, leverage is high and vice versa, a phenomenon that has been dubbed pro-cyclical leverage. We show that this leads to endogenous irregular oscillations, in which gradual increases in stock prices and leverage are followed by drastic market collapses, i.e. a leverage cycle. This phenomenon is studied using simplified models that give a deeper understanding of the dynamics and the nature of the feedback loops and instabilities underlying the leverage cycle. We introduce a flexible leverage regulation policy in which it is possible to continuously tune from pro-cyclical to countercyclical leverage. When the policy is sufficiently countercyclical and bank risk is sufficiently low the endogenous oscillation disappears and prices go to a fixed point. While there is always a leverage ceiling above which the dynamics are unstable, countercyclical leverage can be used to raise the ceiling. We also study the impact on leverage cycles of direct, temporal control of the bank's riskiness via the bank's required Value-at-Risk quantile. Under such a rule the regulator relaxes the Value-at-Risk quantile following a negative stock price shock and tightens it following a positive shock. While such a policy rule can reduce the amplitude of leverage cycles, its effectiveness is highly dependent on the choice of parameters. Finally, we investigate fixed limits on leverage and show how they can control the leverage cycle.Comment: 35 pages, 9 figure

A Functional Limit Theorem for Limit Order Books with State Dependent Price Dynamics

We consider a stochastic model for the dynamics of the two-sided limit order book (LOB). Our model is flexible enough to allow for a dependence of the price dynamics on volumes. For the joint dynamics of best bid and ask prices and the standing buy and sell volume densities, we derive a functional limit theorem, which states that our LOB model converges in distribution to a fully coupled SDE-SPDE system when the order arrival rates tend to infinity and the impact of an individual order arrival on the book as well as the tick size tends to zero. The SDE describes the bid/ask price dynamics while the SPDE describes the volume dynamics.Comment: 43 page