Speculation and Leverage
43 Pages Posted: 24 May 2013
Date Written: May 24, 2013
Speculative episodes typically involve leverage. For example, the well known tulip-mania episode was accompanied by the introduction of foward contracts which allowed speculators to take leveraged positions in tulip bulbs. More recently, the Great Crash of 1929 was exacerbated by leveraged trusts which used leverage to buy stocks. These leveraged trusts could in turn be bought on margin which allowed speculators to hold highly leveraged positions. More recently, speculation in the housing market was accompanied by extreme leverage. In this paper, I provide a continuous time extension of the Harrison-Kreps(1978) speculative model. When the riskless rate is fixed, the speculative premium for each investor is given by their expected present value of excess aggregate consumption over the dividend. They also expect the wealth of other investors with different beliefs to grow unboundedly negative. Letting the riskless rate adjust so that the market for borrowing clears provides endogenous margin requirements which limit borrowing. In addition, the wealth distribution of speculators now becomes a determinant of speculative premia and a fairly rich set of speculative dynamics arise.
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