Abstract of Liquidity and Leverage
By Tobias Adrian and Hyun Song Shin
In a financial system where balance sheets are continuously marked to market, asset price changes show up immediately in changes in net worth, and elicit responses from financial intermediaries who adjust the size of their balance sheets. We document evidence that marked-to-market leverage is strongly procyclical. Such behavior has aggregate consequences. Changes in aggregate balance sheets for intermediaries forecast changes in risk appetite in financial markets, as measured by the innovations in the VIX index. Aggregate liquidity can be seen as the rate of change of the aggregate balance sheet of the financial intermediaries.
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