Leverage Causes Fat Tails and Clustered Volatility

Thurne, Stefan and Farmer, Doyne James and Geanakoplos, John (2009) Leverage Causes Fat Tails and Clustered Volatility. [Other]. p. 7.

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Official URL: http://arxiv.org/abs/0908.1555

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Abstract/Index

We build a very simple model of leveraged asset purchases with margin calls. Investment funds use what is perhaps the most basic nancial strategy, called \value investing", i.e. systematically attempting to buy underpriced assets. When funds do not borrow, the price uctuations 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. When funds use leverage, price uctuations 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. We show that the immediate cause of the increase in extreme risks in our model is the risk control policy of the banks: 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 amplies downward price movements. At the extreme this causes crashes, but the eect is seen at every time scale, producing a power law of price disturbances. A standard (supposedly more sophisticated) risk control policy by individual banks makes these extreme uctuations even worse. Thus it is the very eort to control risk at the local level that creates excessive risk at the aggregate level, which shows up as fat tails and clustered volatility.


Item Type:Report / Paper (Other)
Research documents and activity classification:Working Papers > Refereed Working Papers / of international relevance
Divisions:Department of Business and Management
Uncontrolled Keywords:Systemic risk. Clustered volatility. Fat tails. Crash. Margin calls. Leverage.
MIUR Scientific Area:Area 13 - Economics and Statistics > SECS-P/06 Applied Economics
Deposited By:Silvia Capobianchi
Deposited On:02 Nov 2009 11:38
Last Modified:17 Apr 2013 20:45

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