Margin Trading, Overpricing, and Synchronization Risk

Abstract

We provide experimental evidence that relaxing margin restrictions to allow more short selling can exacerbate overpricing, even though it reduces equilibrium price levels. This is because smart-money traders initially profit more by front-running optimistic investor sentiment than by disciplining prices. When short selling is not possible, competitive pressures among arbitrageurs rapidly drive prices to the equilibrium. However, the risk of margin calls slows the convergence process, because arbitrageurs who sell short too early face substantial losses if they are unable to synchronize their trades with other arbitrageurs (as in Abreu and Brunnermeier. 2002. Journal of Financial Economics 66(2-3):341-60; 2003. Econometrica 71(1):173-204).

Keywords: G14, C92