Faculty of Economics and Business Administration Publications Database

Ambiguity attitudes and the leverage cycle

Bassanin, Marzio
Patella, Valeria
Volume: 129
Month: 03
ISSN-Print: 0022-1996
Link External Source: Online Version
Year: 2021
Keywords: Ambiguity attitudes; Occasionally binding constraints; Kinked beliefs; Leverage cycle; Optimism and pessimism; Sudden reversals

Financial crises originate in debt markets, where beliefs formation about asset values affects the value of collateral, hence the leverage cycles. We introduce novel state-contingent ambiguity attitudes, which endogenously induce pessimism in recessions and optimism in booms, in a model with occasionally binding collateral constraints and exogenous debt supply. Ambiguity is measured in the data through GMM estimation of the Euler equations, and delivers over-extrapolative behaviors through forecasters' beliefs' wedges and forecast errors. Analytically and numerically (global methods), it is shown that the model explains asset price and debt cycle facts. Optimism heightens the build-up of debt and asset prices prior to a crisis event and enhances leverage pro-cyclicality; pessimism heightens the de-leveraging following it.