The Foundation for Advancement of Research in Financial Economics (FARFE) has awarded its eighth Stephen A. Ross Prize in Financial Economics to the paper Leverage Cycles and the Anxious Economy, written by Ana Fostel (PhD '05) from the University of Virginia and Yale's John Geanakoplos. The paper was published in the American Economic Review in 2008. The paper and subsequent work have improved our understanding of the effect of leverage on asset prices and the dynamics of collateralized borrowing against financial assets.
Read the full citation for the prize here.
The biennial Ross Prize is given to a paper published in the last fifteen years and was first awarded in 2008. FARFE established the prize in honor of the late Steve Ross to recognize and encourage significant contributions to research in financial economics.
The award-winning paper develops an innovative analysis of financial booms and busts based on changes in leverage. Financial assets provide agents not only with a stream of future cash flows, but also with collateral against which agents can borrow. When uncertainty in the economy increases, agents’ ability to borrow against collateral declines because it becomes possible that collateral will be insufficient to repay the debt, and hence assets’ margin requirements rise sharply and leverage falls.
Fostel and Geanakoplos show that the variation of leverage over time can generate high volatility and negative skewness in asset returns; financial contagion across assets with independent cash flows; and contagion that is stronger for assets with smaller collateral values. They explain through a series of benchmark cases that their results require agent heterogeneity, incomplete markets, and credit to be granted against financial-asset collateral. Moreover, they show that the price of an asset exceeds the present value of the asset’s future cash flows because of its collateral value, and that this collateral value varies across assets and over time. Hence, they provide a theory of the leverage/margin channel in a rich asset market framework and derive its implications systematically.
The 2022 Nobel Laureate in Economics Douglas Diamond noted that the prize winners “developed new and realistic insights on how endogenous fluctuations in the amount of leverage available to investors lead to highly volatile asset prices and how the changes in leverage available for some assets spill over to the prices of some otherwise unrelated financial assets. This important approach has been extended and generalized by other researchers and it had a significant impact on policy makers.”
The theory in the award-winning paper enhances our understanding of financial booms and busts greatly. The leverage/margin channel analyzed differs from the balance-sheet channel emphasized by Bernanke and Gertler, and Holmstrom and Tirole, and from the collateral channel emphasized by Kiyotaki and Moore. It is sketched in Geanakoplos’ earlier work, including his 1997 and 2003 book chapters, and subsequently exposited in 2010 and further extended by Fostel and Geanakoplos in 2015.
The prize committee was: S. “Vish” Viswanathan from Duke University (chair); Doug Diamond from the University of Chicago; Zhiguo He from the University of Chicago; Ayman Hindy from PIMCO; Nobu Kiyotaki from Princeton University; Christine Parlour from UC Berkeley; and Dimitri Vayanos from LSE.
Founded in 2006, FARFE, a consortium of finance academics and practitioners from around the world, is committed to supporting research in financial economics and to facilitating productive interaction between research and practice in finance.