Reviewing the Leverage Cycle

51 Pages Posted: 27 Sep 2013  

Ana Fostel

University of Virginia

John Geanakoplos

Yale University - Cowles Foundation

Date Written: September 24, 2013

Abstract

We review the theory of leverage developed in collateral equilibrium models with incomplete markets. We explain how leverage tends to boost asset prices, and create bubbles. We show how leverage can be endogenously determined in equilibrium, and how it depends on volatility. We describe the dynamic feedback properties of leverage, volatility, and asset prices, in what we call the Leverage Cycle. We also describe some cross-sectional implications of multiple leverage cycles, including contagion, flight to collateral, and swings in the issuance volume of the highest quality debt. We explain the differences between the leverage cycle and the credit cycle literature. Finally, we describe an agent based model of the leverage cycle in which asset prices display clustered volatility and fat tails even though all the shocks are essentially Gaussian.

Keywords: Leverage, Leverage cycle, Volatility, Collateral equilibrium, Collateral value, Liquidity wedge, Flight to collateral, Contagion, Adverse selection, Agent based models

JEL Classification: E32, E44, G01, G12, G14, G15

Suggested Citation

Fostel, Ana and Geanakoplos, John, Reviewing the Leverage Cycle (September 24, 2013). Cowles Foundation Discussion Paper No. 1918. Available at SSRN: https://ssrn.com/abstract=2330422 or http://dx.doi.org/10.2139/ssrn.2330422

Ana Fostel

University of Virginia ( email )

1400 University Ave
Charlottesville, VA 22903
United States

John D Geanakoplos (Contact Author)

Yale University - Cowles Foundation ( email )

Box 208281
New Haven, CT 06520-8281
United States
203-432-3397 (Phone)
203-432-6167 (Fax)

HOME PAGE: http://cowles.econ.yale.edu/P/au/d_gean.htm

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