Leverage Constraints and Liquidity: What Can We Learn from Margin Trading?
Stockholm School of Economics - Department of Finance; Swedish House of Finance; Institute for Financial Research (SIFR)
Yale University - Yale School of Management; Yale University - International Center for Finance
November 1, 2013
We use the unique features of the margin trading system in India to test the hypothesis that there is a causal relationship between traders’ leverage constraints (i.e., their ability to borrow to invest in risky assets) and a stock’s market liquidity. We employ a regression discontinuity design that exploits the threshold rules that determine a stock’s eligibility for margin trading, thus the availability of leverage. Eligibility is revised every month, creating a series of quasi-experiments that provide newly eligible and ineligible stocks with positive or negative shocks to the availability of leverage. When we compare liquidity changes of treatment and control stocks (stocks that are close to the eligibility threshold), we find a number of results that are consistent with theory. First, we establish that liquidity increases when stocks become eligible for margin trading and it decreases following ineligibility. Using available data on margin financing activity at the individual stock level, we find that it is the intense use of margin trading facilities that drives this result. Finally, we explore the dynamics of commonality in liquidity and document some evidence consistent with the view that leverage constraints are important drivers of liquidity comovement.
Number of Pages in PDF File: 49
Keywords: Traders' Leverage, Market Liquidity, Funding Liquidity
JEL Classification: G10, G14working papers series
Date posted: November 19, 2013 ; Last revised: January 26, 2014
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