CFDP 1877R

Leverage and Default in Binomial Economies: A Complete Characterization

Author(s): 

Publication Date: September 2012

Revision Date: July 2013

Pages: 39

Abstract: 

Our paper provides a complete characterization of leverage and default in binomial economies with financial assets serving as collateral. First, our Binomial No-Default Theorem states that any equilibrium is equivalent (in real allocations and prices) to another equilibrium in which there is no default. Thus actual default is irrelevant, though the potential for default drives the equilibrium and limits borrowing. This result is valid with arbitrary preferences and endowments, arbitrary promises, many assets and consumption goods, production, and multiple periods. We also show that the no-default equilibrium would be selected if there were the slightest cost of using collateral or handling default. Second, our Binomial Leverage Theorem shows that equilibrium LTV for non-contingent debt contracts is the ratio of the worst-case return of the asset to the riskless rate of interest. Finally, our Binomial Leverage-Volatility theorem provides a precise link between leverage and volatility.

Keywords: 

Endogenous leverage, Default, Collateral equilibrium, Financial asset, Binomial economy, VaR, Diluted leverage, Volatility

JEL Classification Codes:  D52, D53, E44, G01, G11, G12