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"Overreaction" of Asset Prices in General Equilibrium

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Listed author(s):
  • S. Rao Aiyagari
  • Mark Gertler

Abstract

We attempt to explain the overreaction of asset prices to movements in short-term interest rates, dividends, and asset supplies. The key element of our explanation is a margin constraint that traders face which limits their leverage to a fraction of the value of their assets. Traders may lever themselves further, either directly by borrowing short term or indirectly by engaging in futures and options trading, so that the scenario is relevant to contemporary financial markets. When some shock pushes asset prices to a low enough level at which the margin constraint binds, traders are forced to liquidate assets. This drives asset prices below what they would be with frictionless markets. Also, a shock which simply increases the likelihood that the margin constraint will bind can have a very similar effect on asset prices. We construct a general equilibrium model with margin constrained traders and derive some qualitative properties of asset prices. We present an analytical solution for a deterministic version of the model and a simple numerical computation of the stochastic version.

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Paper provided by National Bureau of Economic Research, Inc in its series NBER Working Papers with number 6747.

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Date of creation: Oct 1998
Publication status: published as Review of Economic Dynamics, Vol. 2, no. 1 (January 1999): 3-35
Handle: RePEc:nbr:nberwo:6747
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  • G1 - Financial Economics - - General Financial Markets
  • E0 - Macroeconomics and Monetary Economics - - General

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  1. Abel, Andrew B, 1990. "Asset Prices under Habit Formation and Catching Up with the Joneses," American Economic Review, American Economic Association, vol. 80(2), pages 38-42, May.
  2. Gikas A. Hardouvelis, 1988. "Margin requirements and stock market volatility," Quarterly Review, Federal Reserve Bank of New York, issue Sum, pages 80-89.
  3. Aiyagari, S. Rao & Gertler, Mark, 1991. "Asset returns with transactions costs and uninsured individual risk," Journal of Monetary Economics, Elsevier, vol. 27(3), pages 311-331, June.
  4. John Y. Campbell, 1995. "Some Lessons from the Yield Curve," Journal of Economic Perspectives, American Economic Association, vol. 9(3), pages 129-152, Summer.
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  6. John Y. Campbell & John H. Cochrane, 1994. "By Force of Habit: A Consumption-Based Explanation of Aggregate Stock Market Behavior," CRSP working papers 412, Center for Research in Security Prices, Graduate School of Business, University of Chicago.
  7. Kandel, Shmuel & Stambaugh, Robert F., 1991. "Asset returns and intertemporal preferences," Journal of Monetary Economics, Elsevier, vol. 27(1), pages 39-71, February.
  8. Greenwald, Bruce C & Stein, Jeremy, 1988. "The Task Force Report: The Reasoning behind the Recommendations," Journal of Economic Perspectives, American Economic Association, vol. 2(3), pages 3-23, Summer.
  9. Heaton, John & Lucas, Deborah J, 1996. "Evaluating the Effects of Incomplete Markets on Risk Sharing and Asset Pricing," Journal of Political Economy, University of Chicago Press, vol. 104(3), pages 443-487, June.
  10. Constantinides, George M, 1990. "Habit Formation: A Resolution of the Equity Premium Puzzle," Journal of Political Economy, University of Chicago Press, vol. 98(3), pages 519-543, June.
  11. Leland, Hayne & Rubinstein, Mark, 1988. "Comments on the Market Crash: Six Months After," Journal of Economic Perspectives, American Economic Association, vol. 2(3), pages 45-50, Summer.
  12. Eden, Benjamin & Jovanovic, Boyan, 1994. "Asymmetric Information and the Excess Volatility of Stock Prices," Economic Inquiry, Western Economic Association International, vol. 32(2), pages 228-235, April.
  13. Lucas, Robert E, Jr, 1978. "Asset Prices in an Exchange Economy," Econometrica, Econometric Society, vol. 46(6), pages 1429-1445, November.
  14. Aiyagari, S. Rao & Gertler, Mark, 1991. "Asset returns with transactions costs and uninsured individual risk," Journal of Monetary Economics, Elsevier, vol. 27(3), pages 311-331, June.
  15. Allen, Franklin & Gale, Douglas, 1994. "Limited Market Participation and Volatility of Asset Prices," American Economic Review, American Economic Association, vol. 84(4), pages 933-955, September.
  16. Calomiris, Charles W & Kahn, Charles M, 1991. "The Role of Demandable Debt in Structuring Optimal Banking Arrangements," American Economic Review, American Economic Association, vol. 81(3), pages 497-513, June.
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