Divergent Reference-Dependent Risk-Attitudes and Endogenous Collateral Constraints

70 Pages Posted: 20 Sep 2017 Last revised: 10 Sep 2018

See all articles by Giuliano Curatola

Giuliano Curatola

University of Siena - Department of Economics and Statistics; Leibniz Institute for Financial Research SAFE

Ester Faia

Goethe University Frankfurt; Centre for Economic Policy Research (CEPR)

Date Written: December 2016

Abstract

The booms preceding financial crises typically feature high exposure to risky assets, high leverage, asset price growth and low debt margins, which are then followed by sharp de-leveraging after the crisis. We build a model that endogenously generates such heightened leverage/deleverage cycle and asset price boom/bust with three elements. First borrowers exhibit gain-loss preferences around a time-varying reference level, hence they are increasingly risk tolerant at the upper tails and this fosters debt and risky asset demand, while they are loss-averse on the lower tails, something which fosters de-leveraging. Second they are subject to occasionally binding collateral constraints and third, there is heterogeneity in risk-attitudes between borrowers and lenders. The latter implies that the debt margin varies endogenously and countercyclically to close the gap between lenders/borrowers evaluations (namely debt demand and supply). We solve the model analytically and numerically, through a global method, namely policy function iterations with endogenously Markov-switching regimes. Numerically the model matches well several moments for asset prices, returns, equity premia and Sharpe ratio, the volatility of leverage, its procyclicality and the counter-cyclicality of the debt margins.

Keywords: endogenous price of risk, excessive leverage, loss averse borrowers, occasionally binding constraints, risk-tolerance

JEL Classification: E0, E5, G01

Suggested Citation

Curatola, Giuliano and Faia, Ester, Divergent Reference-Dependent Risk-Attitudes and Endogenous Collateral Constraints (December 2016). CEPR Discussion Paper No. DP11678. Available at SSRN: https://ssrn.com/abstract=3039014

Giuliano Curatola (Contact Author)

University of Siena - Department of Economics and Statistics ( email )

Piazza San Francesco 7
Siena, Siena 53100
Italy

Leibniz Institute for Financial Research SAFE ( email )

(http://www.safe-frankfurt.de)
Theodor-W.-Adorno-Platz 3
Frankfurt am Main, 60323
Germany

Ester Faia

Goethe University Frankfurt ( email )

Grüneburgplatz 1
Frankfurt am Main, 60323
Germany

Centre for Economic Policy Research (CEPR) ( email )

London
United Kingdom

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