The Department of Economics Macroeconomics Seminar Series presents

"A Theory of Power Law Distributions for the Returns to Capital and of the Credit Spread Puzzle"
with Francois Geerolf, Assistant Professor of Economics, UCLA

Wednesday, October 8, 2014
3:30-5:00 p.m.
Social Science Plaza B, Room 3218

Geerolf builds a model of the cross section of leverage ratios for borrowers - for example, traders or entrepreneurs - assuming heterogeneous beliefs about future asset returns and endogenous collateral constraints a la Geanakoplos (1997). Under minimal assumptions on the underlying distribution of beliefs, the leverage ratios of borrowers follow a Pareto distribution in the upper tail, with an endogenous tail coefficient equal to two, a prediction precisely verified for hedge funds in the TASS database. This Pareto distribution can lead to similar Pareto distributions for the returns of borrowers, be they investment bankers or entrepreneurs, with empirically plausible Pareto-Lorenz coefficients between one and three, providing a new intuition for the skewness of the income distribution. In the model, borrowers and lenders are matched assortatively according to their relative levels of optimism, which can help explain the Over-The-Counter structure of many collateralize asset markets : borrowers with a relatively higher valuation for the asset effectively borrow from more optimistic lenders with a lower collateral requirement. Finally, interest rates earned by lenders are not linked to expected default probabilities, which can shed a new light on the credit spread puzzle.

For further information, please contact Maria Hernandez, or 949.824.4834.

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