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Leverage and Market Stability: The Role of Margin Rules and Price Limits

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  • Chowdhry, Bhagwan
  • Nanda, Vikram

Abstract

The authors show that, when some investors hold levered portfolios by engaging in margin borrowing, repeated rounds of trading can result in market instability--in the sense that prices can move rationally--even in the absence of any change in fundamentals. They show this with a simple model in which all agents are rational and symmetrically informed. The authors discuss welfare implications of price stability and explore the effects of market composition and market trading rules on the stability of the market. A major result of this article is that price limits might enhance market stability by excluding potentially destabilizing market prices. Copyright 1998 by University of Chicago Press.

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Bibliographic Info

Article provided by University of Chicago Press in its journal Journal of Business.

Volume (Year): 71 (1998)
Issue (Month): 2 (April)
Pages: 179-210

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Handle: RePEc:ucp:jnlbus:v:71:y:1998:i:2:p:179-210

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Web page: http://www.journals.uchicago.edu/JB/

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Cited by:
  1. Antonio E. Bernardo & Ivo Welch, 2004. "Liquidity and Financial Market Runs," The Quarterly Journal of Economics, MIT Press, vol. 119(1), pages 135-158, February.
  2. Fernandes, Marcelo & Rocha, Marco Aurélio dos Santos, 2006. "Are price limits on futures markets that cool? Evidence from the Brazilian Mercantile and Futures Exchange," Economics Working Papers (Ensaios Economicos da EPGE) 630, FGV/EPGE Escola Brasileira de Economia e Finanças, Getulio Vargas Foundation (Brazil).
  3. Henke, Harald & Voronkova, Svitlana, 2005. "Price limits on a call auction market: Evidence from the Warsaw Stock Exchange," International Review of Economics & Finance, Elsevier, vol. 14(4), pages 439-453.
  4. Ilhyock Shim & Goetz von Peter, 2007. "Distress selling and asset market feedback," BIS Working Papers 229, Bank for International Settlements.
  5. Hirshleifer, David & Subrahmanyam, Avanidhar & Titman, Sheridan, 2002. "Feedback and the Success," University of California at Los Angeles, Anderson Graduate School of Management qt2b82s539, Anderson Graduate School of Management, UCLA.
  6. Bernardo, Antonio E. & Welch, Ivo, 2013. "Leverage and preemptive selling of financial institutions," Journal of Financial Intermediation, Elsevier, vol. 22(2), pages 123-151.
  7. Levy, Tamir & Qadan, Mahmod & Yagil, Joseph, 2013. "Predicting the limit-hit frequency in futures contracts," International Review of Financial Analysis, Elsevier, vol. 30(C), pages 141-148.
  8. Markus K. Brunnermeier & Lasse Heje Pedersen, 2007. "Market liquidity and funding liquidity," LSE Research Online Documents on Economics 24478, London School of Economics and Political Science, LSE Library.
  9. Levy, Tamir & Yagil, Joseph, 2005. "Observed versus theoretical prices under price limit regimes," Journal of Economics and Business, Elsevier, vol. 57(3), pages 208-237.
  10. Antonio E. Bernardo & Ivo Welch, 2002. "Financial Market Runs," NBER Working Papers 9251, National Bureau of Economic Research, Inc.
  11. Yeh, Chia-Hsuan & Yang, Chun-Yi, 2010. "Examining the effectiveness of price limits in an artificial stock market," Journal of Economic Dynamics and Control, Elsevier, vol. 34(10), pages 2089-2108, October.
  12. Xiong, Wei, 2001. "Convergence trading with wealth effects: an amplification mechanism in financial markets," Journal of Financial Economics, Elsevier, vol. 62(2), pages 247-292, November.
  13. M. Kabir Hassan & Anisul M. Islam & Syed Abul Basher, 2000. "Market Efficiency, Time-Varying Volatility and Equity Returns in Bangladesh Stock Market," Working Papers 2002_6, York University, Department of Economics, revised Jun 2002.
  14. Wang, Dingyan & Chong, Terence Tai-Leung & Chan, Wing Hong, 2014. "Price Limits and Stock Market Volatility in China," MPRA Paper 54146, University Library of Munich, Germany.
  15. K. John & A. Koticha & R. Narayanan, . "Margin Rules, Informed Trading in Derivatives and Price Dynamics," New York University, Leonard N. Stern School Finance Department Working Paper Seires 99-047, New York University, Leonard N. Stern School of Business-.
  16. Oehmke, Martin, 2014. "Liquidating illiquid collateral," Journal of Economic Theory, Elsevier, vol. 149(C), pages 183-210.
  17. Albert J. Menkveld & Emiliano Pagnotta & Marius A. Zoican, 2013. "Central Clearing and Asset Prices," Tinbergen Institute Discussion Papers 13-181/IV/DSF67, Tinbergen Institute.
  18. Gong-meng Chen & Oliver Rui & Steven Wang, 2005. "The Effectiveness of Price Limits and Stock Characteristics: Evidence from the Shanghai and Shenzhen Stock Exchanges," Review of Quantitative Finance and Accounting, Springer, vol. 25(2), pages 159-182, September.
  19. James Brugler & Oliver Linton, 2014. "Single stock circuit breakers on the London Stock Exchange: do they improve subsequent market quality?," CeMMAP working papers CWP07/14, Centre for Microdata Methods and Practice, Institute for Fiscal Studies.
  20. Sheng Guo, 2014. "Margin Requirements and Portfolio Optimization: A Geometric Approach," Working Papers 1406, Florida International University, Department of Economics.

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