Discussion paper

DP13875 Ambiguity Attitudes, Leverage Cycle and Asset Prices

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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Citation

Faia, E and V Patella (2019), ‘DP13875 Ambiguity Attitudes, Leverage Cycle and Asset Prices‘, CEPR Discussion Paper No. 13875. CEPR Press, Paris & London. https://cepr.org/publications/dp13875