Publication Date: July 2010
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
JEL Classification Codes: D52, D53, E44, G01, G11, G12