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.Endogenous leverage, Post-bad news volatility, Post-good news volatility, Volatility smile

Why Does Bad News Increase Volatility and Decrease Leverage?

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.Collateral, Endogenous leverage, VaR, Volatility, Volatility smile

Why does Bad News Increase Volatility and Decrease Leverage?

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 procyclical leverage. The result also gives a 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

Monetary policy and risk taking : [draft january 2013]

We assess the effects of monetary policy on bank risk to verify the existence of a risk-taking channel - monetary expansions inducing banks to assume more risk. We first present VAR evidence confirming that this channel exists and tends to concentrate on the bank funding side. Then, to rationalize this evidence we build a macro model where banks subject to runs endogenously choose their funding structure (deposits vs. capital) and risk level. A monetary expansion increases bank leverage and risk. In turn, higher bank risk in steady state increases asset price volatility and reduces equilibrium output

Emerging Markets in an Anxious Global Economy

We provide a theory of pricing for emerging asset classes, like emerging markets, that are not yet mature enough to be attractive to the general public. Our model provides an explanation for the volatile access of emerging economies to international financial markets and for several stylized facts we identify in the data during the 1990's. We present a general equilibrium model with incomplete markets and endogenous collateral and an extension encompassing adverse selection. We show that contagion, flight to liquidity and issuance rationing can occur in equilibrium during what we call global anxious times.Margin, Leverage cycle, Liquidity preference, Collateral value, Informational volatility, Contagion, Portfolio effect, Flight to liquidity, Asymmetric information, Issuance rationing, Anxious economy, Emerging markets, High yield, Market closures

Asymmetric dynamics in the correlations of global equity and bond returns

JEL Classification: F3, G1, C5Correlation, International Finance, Variance Targeting

The Economic Implications of Corporate Financial Reporting

We survey 401 financial executives, and conduct in-depth interviews with an additional 20, to determine the key factors that drive decisions related to reported earnings and voluntary disclosure. The majority of firms view earnings, especially EPS, as the key metric for outsiders, even more so than cash flows. Because of the severe market reaction to missing an earnings target, we find that firms are willing to sacrifice economic value in order to meet a short-run earnings target. The preference for smooth earnings is so strong that 78% of the surveyed executives would give up economic value in exchange for smooth earnings. We find that 55% of managers would avoid initiating a very positive NPV project if it meant falling short of the current quarter's consensus earnings. Missing an earnings target or reporting volatile earnings is thought to reduce the predictability of earnings, which in turn reduces stock price because investors and analysts hate uncertainty. We also find that managers make voluntary disclosures to reduce information risk associated with their stock but try to avoid setting a disclosure precedent that will be difficult to maintain. In general, management's views provide support for stock price motivations for earnings management and voluntary disclosure, but provide only modest evidence in support of other theories of these phenomena (such as debt, political cost and bonus plan based hypotheses).

A Primer on Financial Contagion

This paper presents a unified framework to highlight possible channels for the international transmission of financial shocks. We first review the different definitions and measures of contagion used in the literature. We then use a simple multi-country asset pricing model to cast the main elements of the current debate on contagion and provide a stylized account of how a crisis in one country can spread to the world economy. In particular, the model shows how crises can be transmitted across countries, without assuming market imperfections or DG KRF portfolio management rules. Finally, tracking our classification, we survey the results obtained in the empirical literature on contagion.contagion, financial crisis, contagion

What Defines 'News' in Foreign Exchange Markets

This paper examines whether the traditional sets of macro surprises, that most of the literature considers, are the only sorts of news that can explain exchange rate movements. We examine the intra-daily influence of a broad set of news reports, including variables which are not typically considered "fundamentals" in the context of standard models of exchange rate determination, and ask whether they too help predict exchange rate behavior. We also examine whether "news" not only impacts exchange rates directly, but also influences exchange rates via order flow (signed trade volume). Our results indicate that along with the standard fundamentals, both non-fundamental news and order flow matter, suggesting that future models of exchange rate determination ought to include all three types of explanatory variables.