Dynamic Leveraging–Deleveraging Games
Andreea Minca, Johannes Wissel
Operations Research · 2020 · Volume 68 · Issue 1
Abstract
We introduce a new mechanism for leverage dynamics, based on a multiperiod game of lenders with differentiated beliefs about the firm’s fundamental returns. The game features strategic substitutability for low existing leverage and strategic complementarity for high existing leverage. The resulting leverage process exhibits a mean-reverting regime around a long-run level, as long as it stays below an instability level. Above the instability level, leverage becomes explosive. We validate our model empirically using aggregate returns of financial firms over the 10-year period 2001–2010. Our model is consistent with the leveraging/deleveraging of this period and with the 2008 collapse in short-term debt.
Keywords
financial institutions, games/group decisions, Financial Engineering, systemic risk, debt capacity, funding liquidity risk, Nash equilibrium, heterogeneous beliefs
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