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Title: Ambiguity Attitudes, Leverage Cycle and Asset Prices

Author(s): Marzio Bassanin, Ester Faia and Valeria Patella

Publication Date: July 2019

Keyword(s): ambiguity attitudes, asset price cycle, kinked multiplier preferences, leverage cycle and occasionally binding constraints

Programme Area(s): Financial Economics, International Macroeconomics and Finance and Monetary Economics and Fluctuations

Abstract: Financial crises often originate in debt markets, where collateral constraints and opacity of asset values generate intrinsic instability. In such ambiguous contexts endogenous beliefs formation plays a crucial role in explaining asset price and leverage cycles. We introduce state-contingent ambiguity attitudes embedding ambiguity aversion and seeking, which endogenously induces pessimism (left-skewed beliefs) in recessions and optimism (rightskewed beliefs) in booms, in a model where borrowers face occasionally binding collateral constraints. We use GMM estimation with latent value functions to estimate the ambiguity attitudes process. By simulating a crisis scenario in our model we show that optimism in booms is responsible for higher asset price and leverage growth and pessimism in recessions is responsible for sharper de-leveraging and asset price bursts. Analytically and numerically (using global methods) we show that our state-contingent ambiguity attitudes coupled with the collateral constraints can explain relevant asset price and debt cycle facts around the unfolding of a financial crisis.

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Bibliographic Reference

Bassanin, M, Faia, E and Patella, V. 2019. 'Ambiguity Attitudes, Leverage Cycle and Asset Prices'. London, Centre for Economic Policy Research. https://cepr.org/active/publications/discussion_papers/dp.php?dpno=13875