Leverage causes fat tails and clustered volatility

@article{Thurner2009LeverageCF,
  title={Leverage causes fat tails and clustered volatility},
  author={Stefan Thurner and J. Doyne Farmer and John Geanakoplos},
  journal={Quantitative Finance},
  year={2009},
  volume={12},
  pages={695 - 707}
}
We build a simple model of leveraged asset purchases with margin calls. Investment funds use what is perhaps the most basic financial strategy, called ‘value investing’, i.e. systematically attempting to buy underpriced assets. When funds do not borrow, the price fluctuations of the asset are approximately normally distributed and uncorrelated across time. This changes when the funds are allowed to leverage, i.e. borrow from a bank, which allows them to purchase more assets than their wealth… 
Leverage cycles when banks have a choice
Leveraged investing can aggravate crises when dropping asset prices force sales in falling markets. Leverage control policies introduced to coun- teract this could lead to agents targeting the
Leverage cycles when banks have a choice Cars Hommes
Leveraged investing can aggravate crises when dropping asset prices force sales in falling markets. Leverage control policies introduced to counteract this could lead to agents targeting the maximal
Impact-adjusted valuation and the criticalty of leverage
The practice of valuation by marking-to-market with current trading prices is seriously flawed. Under leverage the problem is particularly dramatic: due to the concave form of market impact, selling
The Dynamics of the Leverage Cycle
We present a simple agent-based model of a financial system composed of leveraged investors such as banks that invest in stocks and manage their risk using a Value-at-Risk constraint, based on
Market Liquidity and Heterogeneity in the Investor Decision Cycle
During liquidity shocks such as occur when margin calls force the liquidation of leveraged positions, there is a widening disparity between the reaction speed of the liquidity demanders and the
The Effect of Leverage on Financial Markets∗†
When people get excited about their prospects on the stock market, they borrow money from the bank to invest. This leverage effectively couples the bank to the stock market. Thus, interest rates
Models of systemic risk in financial markets
This thesis studies systemic risk in financial markets and how it emerges through dynamical and structural amplification mechanisms. In part (1) I study the dynamics and control of Basel leverage
An Agent-Based Model of Dynamics in Corporate Bond Trading
We construct a heterogeneous agent-based model of the corporate bond market capturing the interaction of market maker behaviour, fund trading strategies, and cash allocation by investors in funds to
...
...

References

SHOWING 1-10 OF 62 REFERENCES
Liquidity, Default and Crashes: Endogenous Contracts in General Equilibrium
The possibility of default limits available liquidity. If the potential default draws nearer, a liquidity crisis may ensue, causing a crash in asset prices, even if the probability of default barely
Investment rules, margin, and market volatility
T he Brady Commission report [1988] ascribes the stock market break in mid-October 1987 in large part to “mechanical, price-insensitive selling by a number of institutions employing portfolio
Market Liquidity and Funding Liquidity
We provide a model that links an asset's market liquidity - i.e., the ease with which it is traded - and traders' funding liquidity - i.e., the ease with which they can obtain funding. Traders
Bubbles and crashes: Escape dynamics in financial markets
We develop a financial market model focused on fund managers who continuously adjust their exposure to risk in response to the payoff gradient. The base model has a stable equilibrium with classic
Optimal leverage from non-ergodicity
In modern portfolio theory, the balancing of expected returns on investments against uncertainties in those returns is aided by the use of utility functions. The Kelly criterion offers another
Liquidity and Leverage
In a financial system in which balance sheets are continuously marked to market, asset price changes appear immediately as changes in net worth, and eliciting responses from financial intermediaries
Leverage Cycles and the Anxious Economy
We provide a pricing theory for emerging asset classes, like emerging markets, that are not yet mature enough to be attractive to the general public. We show how leverage cycles can cause contagion,
Market Returns and Mutual Fund Flows
With the increased popularity of mutual funds come increased concerns. Namely, could a sharp drop in stock and bond prices set off a cascade of redemptions by mutual fund investors and could the
Capital Structure, Credit Risk, and Macroeconomic Conditions
This paper develops a framework for analyzing the impact of macroeceomic conditions on credit risk and dynamic capital structure choice. We begin by observing that when cash flows depend on current
...
...