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

Collateral Restrictions and Liquidity Under-Supply: A Simple Model

We show that very little is needed to create liquidity under-supply in equilibrium. Credit constraints on demand by themselves can cause an under-supply of liquidity, without the uncertainty, intermediation, asymmetric information or complicated international financial framework used in other models in the literature. We show that the under-supply is a non-monotone function of the demand distortion that causes it, a result that may have interesting implications for emerging markets economies. Finally, when we make the credit constraint endogenous, the inefficiency can be large due to the presence of a multiplier.Liquidity under-supply, Credit constraint, Non-monotonicity, Multiplier, Collateral equilibrium

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

Latin America's Access to International Capital Markets: Good Behavior or Global Liquidity?

This paper examines Latin America’s access to international capital markets from 1980 to 2005, with particular attention to the role of domestic and external factors. To capture access to international markets, we use primary gross issuance in international bond, equity, and syndicated-loan markets. Using panel estimation, we find that sound fundamentals matter. For example, Argentina, Brazil, and Chile’s superb performance in capital markets during the early 1990s has been in large part driven by better fundamentals. However, the upsurge in international lending to Latin America starting in 2003 has been mainly driven by a dramatic increase in global liquidity.

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

Tranching, CDS and Asset Prices: How Financial Innovation Can Cause Bubbles and Crashes

We show how the timing of financial innovation might have contributed to the mortgage boom and then to the bust of 2007-2009. We study the effect of leverage, tranching, securitization and CDS on asset prices in a general equilibrium model with collateral. We show why tranching and leverage tend to raise asset prices and why CDS tend to lower them. This may seem puzzling, since it implies that creating a derivative tranche in the securitization whose payoffs are identical to the CDS will raise the underlying asset price while the CDS outside the securitization lowers it. The resolution of the puzzle is that the CDS lowers the value of the underlying asset since it is equivalent to tranching cash.Financial innovation, Endogenous leverage, Collateral equilibrium, CDS, Tranching and asset prices

Endogenous Leverage: VaR and Beyond

We study endogenous leverage in a general equilibrium model with incomplete markets. We prove that in any binary tree leverage emerges in equilibrium at the maximum level such that VaR = 0, so there is no default in equilibrium, provided that agents get no utility from holding the collateral. When the collateral does affect utility (as with housing) or when agents have sufficiently heterogenous beliefs over three or more states, VaR = 0 fails to hold in equilibrium. We study commonly used examples: an economy in which investors have heterogenous beliefs and a CAPM economy consisting of investors with different risk aversion. We find two main departures from VaR = 0. First, both examples show that with enough heterogeneity among the investors, equilibrium default is normal. Second, we find that more than one contract is actively traded in equilibrium on the same collateral, that is, the same asset is bought at different margin requirements by different agents. Finally, we study the relationship between leverage and asset prices. We provide an example that shows that as the regulatory authority gradually relaxes leverage restrictions from low levels and permits leverage to rise, asset prices start to rise, but eventually increased leverage paradoxically tends to reduce asset prices because the risky bonds become substitutes for the asset used as collateral.Endogenous leverage, Collateral equilibrium, VaR, Asset prices