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Leverage

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  • Santos, Tano
  • Veronesi, Pietro

Abstract

A frictionless general equilibrium model featuring heterogeneous time-varying risk tolerance explains the business cycle dynamics of intermediary leverage, aggregate credit, and other asset markets’ facts. In booms, when risk tolerance is high, households borrow more and aggregate credit increases funded by higher intermediary debt. In recessions, credit contracts and intermediaries delever. Yet, their debt-to-equity ratios increase as equity drops when risk aversion increases. Because households borrow more or less as their risk tolerance increases or decreases, the intermediary’s balance sheet forecasts stock returns both in the time series and the cross section. Moreover, credit expansions correlate with negatively skewed stock returns, low credit spreads, and predict lower future returns.

Suggested Citation

  • Santos, Tano & Veronesi, Pietro, 2022. "Leverage," Journal of Financial Economics, Elsevier, vol. 145(2), pages 362-386.
  • Handle: RePEc:eee:jfinec:v:145:y:2022:i:2:p:362-386
    DOI: 10.1016/j.jfineco.2021.09.001
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    More about this item

    Keywords

    Intermediary; Heterogeneity; Risk aversion;
    All these keywords.

    JEL classification:

    • G01 - Financial Economics - - General - - - Financial Crises
    • G11 - Financial Economics - - General Financial Markets - - - Portfolio Choice; Investment Decisions
    • G20 - Financial Economics - - Financial Institutions and Services - - - General

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