Leverage causes fat tails and clustered volatility

DOI10.1080/14697688.2012.674301zbMATH Open1278.91154arXiv0908.1555OpenAlexW3125264555WikidataQ56689100 ScholiaQ56689100MaRDI QIDQ2869960FDOQ2869960

Authors: J. Doyne Farmer, Stefan Thurner, John D. Geanakoplos 

Publication date: 17 January 2014

Published in: Quantitative Finance (Search for Journal in Brave)

Abstract: 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 normally distributed and uncorrelated across time. All this changes when the funds are allowed to leverage, i.e. borrow from a bank, to purchase more assets than their wealth would otherwise permit. During good times competition drives investors to funds that use more leverage, because they have higher profits. As leverage increases price fluctuations become heavy tailed and display clustered volatility, similar to what is observed in real markets. Previous explanations of fat tails and clustered volatility depended on "irrational behavior", such as trend following. Here instead this comes from the fact that leverage limits cause funds to sell into a falling market: A prudent bank makes itself locally safer by putting a limit to leverage, so when a fund exceeds its leverage limit, it must partially repay its loan by selling the asset. Unfortunately this sometimes happens to all the funds simultaneously when the price is already falling. The resulting nonlinear feedback amplifies large downward price movements. At the extreme this causes crashes, but the effect is seen at every time scale, producing a power law of price disturbances. A standard (supposedly more sophisticated) risk control policy in which individual banks base leverage limits on volatility causes leverage to rise during periods of low volatility, and to contract more quickly when volatility gets high, making these extreme fluctuations even worse.

Full work available at URL: https://arxiv.org/abs/0908.1555

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zbMATH Keywords

leveragesystemic riskfat tailscrashclustered volatilitymargin calls

Mathematics Subject Classification ID

Economic time series analysis (91B84) Statistical methods; risk measures (91G70) Portfolio theory (91G10)

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Cited In (20)

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• The dynamics of the leverage cycle
• The impact of systemic and illiquidity risk on financing with risky collateral
• To bail-out or to bail-in? Answers from an agent-based model
• Endogenous leverage and asset pricing in double auctions
• When micro prudence increases macro risk: the destabilizing effects of financial innovation, leverage, and diversification
• Equilibrium with computationally constrained agents
• Basel III capital surcharges for G-SIBs are far less effective in managing systemic risk in comparison to network-based, systemic risk-dependent financial transaction taxes
• Why does bad news increase volatility and decrease leverage?
• High frequency trading strategies, market fragility and price spikes: an agent based model perspective
• Prices, debt and market structure in an agent-based model of the financial market
• Connectivity, information jumps, and market stability: an agent-based approach
• An agent-based model of corporate bond trading
• Tail-risk protection trading strategies
• Adverse effects of leverage and short-selling constraints in a financial market model with heterogeneous agents
• Elimination of systemic risk in financial networks by means of a systemic risk transaction tax
• Speculative multipliers on DeFi: quantifying on-chain leverage risks

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