Leverage causes fat tails and clustered volatility

By Stefan Thurner 4, J. D. Farmer, John D. Geanakoplos, James Tobin Pro. 2009

262 citations recorded by the source corpus.

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 would otherwise permit. During good times, funds that use more leverage have higher profits, increasing their wealth and making them dominant in the market. However, if a downward price fluctuation occurs while one or more funds is fully leveraged, the resulting margin call causes them to sell into an already falling market, amplifying the downward price movement. If the funds hold large positions in the asset, this can cause substantial losses. This in turn leads to clustered volatility: before a crash, when the value funds are dominant, they damp volatility, and after the crash, when they suffer severe losses, volatility is high. This leads to power-law tails, which are both due to the leverage-induced crashes and due to the clustered volatility induced by the wealth dynamics. This is in contrast to previous explanations of fat tails and clustered volatility, which depended on ‘irrational behavior’, such as trend following. 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 becomes high, making these extreme fluctuations even worse.

Subfields: Economics and Econometrics, Finance

View Paper: https://www.semanticscholar.org/paper/62921fff84604e98ed7b2a4407d5d178c87f33be

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Citations in the corpus

Elimination of systemic risk in financial networks by means of a systemic risk transaction tax (2014, background): “…can potentially wipe out the financial system by a de-leveraging cascade (Minsky 1992, Adrian and Shin 2008, Fostel and Geanakoplos 2008, Brunnermeier and Pedersen 2009, Geanakoplos 2010, Thurner et al. 2012, Caccioli et al. 2012, Poledna et al. 2014,Aymanns and Farmer 2015, Caccioli et al. 2015).”
Econophysics review: II. Agent-based models (2011, unknown): “( 2009 ), who investigate the effects of the use of leverage and margin calls on the stability of a market, and Yakovenko and Rosser ( 2009 ), who provide a brief overview of the study of wealth distributions and inequalities.”
Systemic risk-efficient asset allocations: Minimization of systemic risk as a network optimization problem (2018, background): “In case of large losses, this can deteriorate the equity positions of the institutions (Cifuentes et al., 2005; Thurner et al., 2012; Cont and Schaanning, 2017).”
The multi-layer network nature of systemic risk and its implications for the costs of financial crises (2015, unknown): “[14] S.”
Complex agent-based macroeconomics: a manifesto for a new paradigm (2010, background): “... failure in realizing this plain fact is a key determinant of the recent financial turmoil; that a macroeconomic system in general—and the financial system in particular—is in its essence a network, with nodes defined by agents and links defined by contractual obligations among them; that systemi”
Econophysics: Empirical facts and agent-based models (2009, unknown): “As illustrations, let us mention Iori et al. (2006), which models the interbank market and investigates systemic risk, Thurner et al. (2009), which investigates the effects of use of leverage and margin calls on the stability of a market and Yakovenko and Rosser (2009), which provides a brief…”
A Third Wave in the Economics of Climate Change (2015, background): “…Veit 2008; Sun and Tesfatsion 2007), emissions trading markets (Zhang et al. 2011), housing markets (Geanakoplos et al. 2012), financial markets, (Thurner et al. 2012; Caccioli et al. 2012; Aymanns and Farmer 2015; Poledna et al. 2014), technology adoption, lock-in and transfer (Frenken et al.…”
Stability analysis of financial contagion due to overlapping portfolios (2012, unknown): “This should allow the system to develop endogenous crisis similar to the ones observed in [26], and to generate the systemic instabilities induced by leverage and mark-to-market accounting practices discussed in [10].”