Margin Requirements, Risk Taking, and Multifactor Models

Abstract

When investors anticipate the Fed increasing margin requirements, they bid up the riskier stocks in the long legs of hedge portfolios associated with the market, HML, and SMB factors relative to the less risky stocks in the short legs. Following such a policy change, the returns on these hedge portfolios decline, implying lower subsequent compensation for bearing the risk associated with these three factors. In contrast, margin requirements are unrelated to returns on the momentum factor. Our evidence suggests that investors adjust their risk exposures to the market, SMB, and HML factors when leverage constraints are changed, but not momentum.

Keywords: Asset pricing, CAPM, multifactor models, security market line, leverage constraints, margin requirements, risk premia.

JEL Classification: G12, G14, G41