Margin Trading and Comovement During Crises

Abstract

We exploit threshold rules governing margin trading eligibility in India to identify a causal link between margin trading and increased comovement during crises. Margin trading explains more than one quarter of the increase return comovement that we observe during crises. To understand the mechanisms driving this result, we evaluate the relative importance of stock connections through common brokers (who provide margin financing) versus common margin traders. We find that common brokers are most important. Margin-eligible stocks that are more connected through common brokers experience larger crisis-period increases in pairwise return comovement, especially when those brokers’ clients have experienced recent portfolio losses, when their clients have outstanding margin loans in more volatile stocks, and when the brokers are large. These findings are consistent with Brunnermeier and Petersen (2009), in which initial shocks propagate due to the tightening of margin constraints imposed by financial intermediaries.

Keywords: Margin Trading, Comovement, Crisis, Funding Constraints, Leverage, Regression Discontinuity Design