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Role of Leverage in Bubbles and Crashes

  • Hitoshi Matsushima

    (Faculty of Economics, University of Tokyo)

This paper investigates the possibility that an unproductive company with limited debt capacity raises huge funds through share issuances by utilizing a small sign of enthusiasm. We generalize the timing game of Matsushima (2012) by permitting arbitrageurs to use high leverage for purchasing the shares. Thanks to this leverage, any arbitrageur has strong incentive to ride the bubble by continuing to purchase them, instead of timing the market quickly. We show that the harmful bubble persists for a long time as the unique Nash equilibrium. Importantly, this result holds even if the underlying positive feedback traders are not very enthusiastic.

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File URL: http://www.cirje.e.u-tokyo.ac.jp/research/dp/2012/2012cf859.pdf
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Paper provided by CIRJE, Faculty of Economics, University of Tokyo in its series CIRJE F-Series with number CIRJE-F-859.

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Length: 29 pages
Date of creation: Sep 2012
Date of revision:
Handle: RePEc:tky:fseres:2012cf859
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  1. Harrison, J Michael & Kreps, David M, 1978. "Speculative Investor Behavior in a Stock Market with Heterogeneous Expectations," The Quarterly Journal of Economics, MIT Press, vol. 92(2), pages 323-36, May.
  2. Stein, Jeremy C, 1996. "Rational Capital Budgeting in an Irrational World," The Journal of Business, University of Chicago Press, vol. 69(4), pages 429-55, October.
  3. Hitoshi Matsushima, 2010. "Financing Harmful Bubbles," KIER Working Papers 711, Kyoto University, Institute of Economic Research.
  4. Allen F. & Morris S. & Postlewaite A., 1993. "Finite Bubbles with Short Sale Constraints and Asymmetric Information," Journal of Economic Theory, Elsevier, vol. 61(2), pages 206-229, December.
  5. Tobias Adrian & Hyun Song Shin, 2008. "Liquidity and leverage," Staff Reports 328, Federal Reserve Bank of New York.
  6. Hitoshi Matsushima, 2012. "Behavioral Aspects of Arbitrageurs in Timing Games of Bubbles and Crashes," CARF F-Series CARF-F-285, Center for Advanced Research in Finance, Faculty of Economics, The University of Tokyo.
  7. Malcolm Baker & Jeremy C. Stein & Jeffrey Wurgler, 2002. "When Does the Market Matter? Stock Prices and the Investsment of Equity-Dependent Firms," Harvard Institute of Economic Research Working Papers 1978, Harvard - Institute of Economic Research.
  8. Markus K Brunnermeier, 2002. "Bubbles and Crashes," FMG Discussion Papers dp401, Financial Markets Group.
  9. Jose A. Scheinkman & Wei Xiong, 2003. "Overconfidence and Speculative Bubbles," Journal of Political Economy, University of Chicago Press, vol. 111(6), pages 1183-1219, December.
  10. Allen, Franklin & Gorton, Gary, 1993. "Churning Bubbles," Review of Economic Studies, Wiley Blackwell, vol. 60(4), pages 813-36, October.
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