We develop a model of asset trading with financial leverage in an economy with a continuum of investors. The investors are assumed to have diverse and rational beliefs in the sense of being compatible with observed data. We show that an increase in leverage ratio may cause the stock price to rise in the current period because it increases the demand of optimistic investors through a leverage effect, and will result in pyramiding and depyramiding phenomena for stock prices in the subsequent period. Our results also suggest that an increase in leverage ratio also results in an increase in price volatility as well, however, under certain conditions. Price changes from pyramiding effect are also negatively associated with margin requirements. Price changes from depyramiding effect, however, may not be affected when margin calls are not triggered. Furthermore, the influences of dispersion of opinion, investment funds, and investors anticipations are also examined.
Financial Leverage and Market Volatility with Diverse Beliefs
No. E2009007 2009-11