Leverage and Market Stability: The Role of Margin Rules and Price Limits

Abstract

We propose a simple model in which all agents are rational and symmetrically informed. We show that when some investors hold levered portfolios by engaging in margin borrowing, repeated rounds of trading can result in market instability -- in the sense that prices can move rationally, even in the absence of any change in fundamentals. We explore the effects of market composition and market trading rules on the stability of the market. Sufficiently large margin requirements are always associated with stability. Decreasing the margin requirements sufficiently may also ensure stability. A major result of the paper is that price limits might enhance market stability by excluding potentially destabilizing market prices. The tradeoffs involved in choosing an optimal combination of price limits and margin requirements to achieve market stability are analyzed. The possible role of specialists and price continuity rules in enhancing market stability are discussed.

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