CFDP 1762

Why Does Bad News Increase Volatility and Decrease Leverage?


Publication Date: July 2010

Pages: 34


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