Why does bad news increase volatility and decrease leverage?

The literature on endogenous leverage until now shows how an increase in volatility reduces leverage. However, in order to explain procyclical leverage it assumes that bad news increases volatility. This paper explains for the first time why bad news are associated with high volatility. We show that, in a model with endogenous leverage and heterogenous beliefs, most agents have the incentive to invest in technologies that are volatile in bad times and induce pro-cyclical leverage. They choose scary-bad-news-pro-cyclical leverage projects. This result also gives rationale to the pattern of “volatility smiles” observed in the stock options since 1987. Finally, the paper explores further the link between volatility and leverage in more general situations that were not studied before.