Divergent Risk-Attitudes and Endogenous Collateral Constraints

Category: Finance Brown Bag Seminar
When: 25 October 2017
, 14:00
 - 15:00
Where: HoF E.20 ("DZ Bank")
Speaker: Giuliano Curatola

Authors: Giuliano Curatola (Goethe University and SAFE), Ester Faia (Goethe University)

Title: Divergent Risk-Attitudes and Endogenous Collateral Constraints

Abstract: In the booms preceding financial crises borrowers typically exhibit more risk-tolerance at the upper tails relatively to lenders. This results in high exposure to risky assets, leverage and asset price growth and low debt margins, followed by sharp de-leveraging after a financial crisis occurs. We build a model with borrowers featuring gain-loss preferences around a time-varying reference level (borrowers are increasingly risk-tolerant at the upper tails and are loss-averse on the lower tails), who are subject to occasionally binding collateral constraints and with heterogeneity in risk-attitudes between borrowers and lenders (so that debt margins are endogenous). We solve the model analytically and numerically, through policy function iterations with endogenously Markov-switching regimes. The model endogenously generates a heightened leverage/de-leverage cycle and boom/bust in asset prices. Numerically it matches
well several moments for asset prices, returns, equity premia and Sharpe ratio, the volatility of leverage, its procyclicality and the counter-cyclicality of the debt margins.