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Financial leverage and market volatility with diverse beliefs

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  • Wen-Chung Guo
  • Frank Wang
  • Ho-Mou Wu

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Abstract

We develop a model of asset trading with financial leverage in an economy with a continuum of investors. The investors are assumed to have diverse and rational beliefs in the sense of being compatible with observed data. We show that an increase in leverage ratio may cause the stock price to rise in the current period because it increases the demand of optimistic investors through a leverage effect, and will result in pyramiding and depyramiding phenomena for stock prices in the subsequent period. Our results also suggest that an increase in leverage ratio also results in an increase in price volatility as well, however, under certain conditions. Price changes from pyramiding effect are also negatively associated with margin requirements. Price changes from depyramiding effect, however, may not be affected when margin calls are not triggered. Furthermore, the influences of dispersion of opinion, investment funds, and investors anticipations are also examined.
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Suggested Citation

  • Wen-Chung Guo & Frank Wang & Ho-Mou Wu, 2011. "Financial leverage and market volatility with diverse beliefs," Economic Theory, Springer;Society for the Advancement of Economic Theory (SAET), vol. 47(2), pages 337-364, June.
  • Handle: RePEc:spr:joecth:v:47:y:2011:i:2:p:337-364
    DOI: 10.1007/s00199-010-0548-8
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    References listed on IDEAS

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    Citations

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    Cited by:

    1. Wen-Chung Guo & Sy-Ming Guu & Ting-Yun Chang, 2011. "Equilibrium Information Acquisition, Prediction Abilities and Asset Prices," Computational Economics, Springer;Society for Computational Economics, vol. 37(1), pages 89-111, January.
    2. Hiroyuki Nakata, 2013. "Welfare effects of short-sale constraints under heterogeneous beliefs," Economic Theory, Springer;Society for the Advancement of Economic Theory (SAET), vol. 53(2), pages 283-314, June.
    3. Maurizio MOTOLESE & NAKATA Hiroyuki, 2016. "Endogenous Fluctuations and Social Welfare under Credit Constraints and Heterogeneous Beliefs," Discussion papers 16082, Research Institute of Economy, Trade and Industry (RIETI).

    More about this item

    Keywords

    Financial leverage; Diverse beliefs; Stock price volatility; Leverage effect; Pyramiding/depyramiding effect; D84; G12; G18;

    JEL classification:

    • D84 - Microeconomics - - Information, Knowledge, and Uncertainty - - - Expectations; Speculations
    • G12 - Financial Economics - - General Financial Markets - - - Asset Pricing; Trading Volume; Bond Interest Rates
    • G18 - Financial Economics - - General Financial Markets - - - Government Policy and Regulation

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