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Journal of Economic Interaction and Coordination

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01-07-2019 | Regular Article

Margin trade, short sales and financial stability

Authors: Hui Ying Sng, Yang Zhang, Huanhuan Zheng

Published in: Journal of Economic Interaction and Coordination | Issue 3/2020

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Abstract

We model how leveraged trading activities constrained by dynamic funding availability affect financial stability. In the market, customers trade based on the fundamental value of the risky asset and make full payment for their transactions, while speculators take trading position based on margin, which is constantly adjusted by the financier, the fund provider, according to the price volatility. As a result of equilibrium price discontinuity triggered by dynamic margin requirements, trivial shocks to external supply, wealth or fundamental value can be transmitted into asset price crashes or jumps. We find that tightening margin requirements improves (mitigates) the market liquidity in the bull (bear) market, and that imposing short sale constraints helps prevent the price from falling further when the asset is sufficiently under-priced and accelerate price collapse when the asset is over-priced.

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China launched a pilot scheme for margin trade and short sale in 6 designated brokerage houses involving 90 constituent stocks on March 31, 2010. The scheme was gradually expanded to an increasing number of brokerage houses and stocks. In the early stage, the brokerage houses required the customers to have a minimum transaction experience of 18 months and asset holdings ofRMB 500,000 to trade on margin. These constraints were gradually relaxedd as competition among brokerage houses intensified.

In China, retail investors account for as much as 90% of daily turnover, whereas institutional investors are more dominant in developed markets. China’s stock market witness a surge in openings of new trading accounts over the past years. Almost eight million accounts were opened in the first quarter of 2015. With mounting new investors, mostly retail investors, behavior bias and irrational trading preference may be more widespread than in developed markets. Liang and Zhang (2016) show that retail investors in China overweight stocks with lottery features, i.e., stocks with high maximum daily return over the past one month. Stock market in China has often been called a casino manipulated by speculators with share prices bearing little connection to underlying economic conditions, behaving like a classic case of irrational exuberance.

The fundamental value \(v_{t}\) is not directly observable and is often proxied by the present value of a series of estimated future dividend payment or the analysts’ price forecast that is based on both public and private information.

Although speculators are different with any position when the price does not change, in real life they wouldn’t bother to trade if it does not generate any profit, which justifies our assumption of zero position in this case.

The equation includes two special scenarios. When \(I_{t}=0\), only customers trade in the market. When \(p_{t}=v_{t}+\gamma \sigma ^{2}Z_{t}\), only speculators trade in the market. As price changes, the trading behavior by customers and speculators also change. Their collective actions exert impact on prices which subsequently affect their trading actions. Such interactions are the key of the price dynamics.

The long position of speculator can be written as \(x_{t}=\frac{W_{s,t}}{m_{t}}=\frac{W_{s,t}}{p_{t}}\frac{p_{t}}{\overline{\varphi }+\bar{\theta }\left| \Delta p_{t}\right| }\), where the first component captures the demand in the absence of margin trading and the second components reflect the leverage (the higher the leverage, the lower the margin). If the leverage component remains unchanged, the long position would have been larger shall the asset price \(p_{t}\) drops, which help offset the positive supply shock. If the margin is tightened such that \(m_{t}\) increases, the demand would decline, which exacerbates the supply shock.

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Title: Margin trade, short sales and financial stability
Authors: Hui Ying Sng
Yang Zhang
Huanhuan Zheng
Publication date: 01-07-2019
Publisher: Springer Berlin Heidelberg
Published in: Journal of Economic Interaction and Coordination / Issue 3/2020
Print ISSN: 1860-711X
Electronic ISSN: 1860-7128
DOI: https://doi.org/10.1007/s11403-019-00256-3

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