Leverage Constraints and Liquidity
University of Oxford - Said Business School; Stockholm School of Economics - Department of Finance
Yale University - Yale School of Management; Yale University - International Center for Finance
September 28, 2015
Do traders’ leverage constraints drive equity market liquidity? We use the unique features of the margin trading system in India to identify a causal relationship between traders’ leverage constraints and a stock’s market liquidity. To quantify the impact of these constraints, we employ a regression discontinuity design that exploits threshold rules that determine a stock’s margin trading eligibility. We find that liquidity is higher when stocks become eligible for margin trading and that this liquidity enhancement is driven by margin traders’ contrarian strategies. Consistent with downward liquidity spirals due to deleveraging, we also find that this effect reverses during crises.
Number of Pages in PDF File: 67
Keywords: Traders' Leverage, Market Liquidity, Funding Liquidity
JEL Classification: G10, G14
Date posted: November 19, 2013 ; Last revised: September 29, 2015
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