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A leverage-based measure of financial instability

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  • Tepper, Alexander

    () (Federal Reserve Bank of New York)

  • Borowiecki, Karol Jan

Abstract

We employ a model of leverage-induced explosive behavior in financial markets to develop a measure of financial market instability. Specifically, we derive a quantitative condition for how large levered investors can become relative to the whole market before the demand curve for securities suddenly becomes upward-sloping and small price declines cascade as levered investors are forced to liquidate. The size and leverage of all levered investors and the elasticity of demand of unlevered investors define the minimum market size for stability (or MinMaSS), the smallest market size that can support a given group of levered investors. The ratio of actual market size to MinMaSS, termed the instability ratio, can give regulators and policymakers advance warning of financial crises. We apply the instability ratio in an investigation of the 1998 demise of the hedge fund Long-Term Capital Management. We find that a forced liquidation of the fund threatened to destabilize some financial markets, particularly the markets for bank funding and equity volatility.

Suggested Citation

  • Tepper, Alexander & Borowiecki, Karol Jan, 2014. "A leverage-based measure of financial instability," Staff Reports 688, Federal Reserve Bank of New York.
  • Handle: RePEc:fip:fednsr:688
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    References listed on IDEAS

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    Cited by:

    1. Jan K. Solarz, 2015. "Systemic Risk Management. Cognitive Perspective (Zarzadzanie ryzykiem systemu finansowego. Perspektywa poznawcza)," Problemy Zarzadzania, University of Warsaw, Faculty of Management, vol. 13(55), pages 30-46.

    More about this item

    JEL classification:

    • E58 - Macroeconomics and Monetary Economics - - Monetary Policy, Central Banking, and the Supply of Money and Credit - - - Central Banks and Their Policies
    • G01 - Financial Economics - - General - - - Financial Crises
    • G10 - Financial Economics - - General Financial Markets - - - General (includes Measurement and Data)
    • G20 - Financial Economics - - Financial Institutions and Services - - - General

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