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Role of Leverage in Bubbles and Crashes

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  • Hitoshi Matsushima

    (Faculty of Economics, University of Tokyo)

Abstract

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.

Suggested Citation

  • Hitoshi Matsushima, 2012. "Role of Leverage in Bubbles and Crashes," CIRJE F-Series CIRJE-F-859, CIRJE, Faculty of Economics, University of Tokyo.
  • Handle: RePEc:tky:fseres:2012cf859
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    File URL: http://www.cirje.e.u-tokyo.ac.jp/research/dp/2012/2012cf859.pdf
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    References listed on IDEAS

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    1. Malcolm Baker & Jeremy C. Stein & Jeffrey Wurgler, 2003. "When Does the Market Matter? Stock Prices and the Investment of Equity-Dependent Firms," The Quarterly Journal of Economics, Oxford University Press, vol. 118(3), pages 969-1005.
    2. Dilip Abreu & Markus K. Brunnermeier, 2003. "Bubbles and Crashes," Econometrica, Econometric Society, vol. 71(1), pages 173-204, January.
    3. Stein, Jeremy C, 1996. "Rational Capital Budgeting in an Irrational World," The Journal of Business, University of Chicago Press, vol. 69(4), pages 429-455, October.
    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. Matsushima, Hitoshi, 2013. "Behavioral aspects of arbitrageurs in timing games of bubbles and crashes," Journal of Economic Theory, Elsevier, vol. 148(2), pages 858-870.
    6. Emmanuel Farhi & Jean Tirole, 2012. "Bubbly Liquidity," Review of Economic Studies, Oxford University Press, vol. 79(2), pages 678-706.
    7. Hitoshi Matsushima, 2010. "Financing Harmful Bubbles," KIER Working Papers 711, Kyoto University, Institute of Economic Research.
    8. Adrian, Tobias & Shin, Hyun Song, 2010. "Liquidity and leverage," Journal of Financial Intermediation, Elsevier, vol. 19(3), pages 418-437, July.
    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. Franklin Allen & Gary Gorton, 1993. "Churning Bubbles," Review of Economic Studies, Oxford University Press, vol. 60(4), pages 813-836.
    11. J. Michael Harrison & David M. Kreps, 1978. "Speculative Investor Behavior in a Stock Market with Heterogeneous Expectations," The Quarterly Journal of Economics, Oxford University Press, vol. 92(2), pages 323-336.
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