Does Credit Affect Stock Trading? Evidence From the South Sea Bubble

Abstract

We study the relationship between credit, stock trading and prices bubbles. The role of credit in financial bubbles is theoretically ambiguous. On the one hand, it may help rational arbitrageurs to trade against a bubble; on the other hand, it may enable naive speculators to buy overvalued assets. We construct a novel database containing every individual stock transaction in three major British companies during the 1720 South Sea Bubble. We link these transactions to daily margin loan positions and subscription lists of new share issues. We find that margin loan holders acted as extrapolators, i.e., they were more likely to buy (sell) following high (low) past returns. Loan holders also signed up to buy new shares of overvalued companies and incurred large trading losses. Our results suggest that credit provision was instrumental in fueling the bubble.

Keywords: Bubble, Credit Provision, Margin Loans, Investor Behavior

JEL Classification: G01, G12, G21, N23