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Monday, May 16, 2011

Asset Price Cycles and Collateral...

Some intuition on how borrowing constraints can lead to cycles in asset prices.  My explanation below is heavily influenced by Geanakoplos (1997), and Kiyotaki and Moore (1997).  First I will explain why asset prices will be more volatile in a world where investors can buy on margin, and then I will provide some intuition as to why this process can lead to cycles in assets prices.

Suppose that you are an investor, and that you have the ability to buy assets on margin (i.e., you are allowed to use the asset that you wish to purchase as collateral to borrow the funds necessary to make the purchase).  Note, in passing, that because the borrower keeps position of the collateral during the period of repayment, a fairly sophisticated courts system is a prerequisite for buying on margin.

Buying on margin will allow those agents with the most optimistic view of the future value of those assets (in the Geanakoplos (1997) framework optimistic agents are those agents whose marginal utility of holding the asset is the highest) can hold a larger fraction of those assets in their portfolio than would have been possible absent the ability to buy on margin.  This will lead (initially) to an increase in asset prices because:
  1. Asset prices will be higher because every agent can now afford to buy more assets (because of the ability to buy on margin)
  2. The marginal buyer of the assets will be an agent with strictly higher marginal utility (compared to a world without the ability to buy on margin).
The ability to buy on margin leads the optimistic agents to have high levels of leverage.  It is the leverage that creates the volatility in asset prices.  To see the leverage effect consider the effects of "bad news" on the price of an asset:
  1. Every agent now values the asset less than before the arrival of the "bad news"
  2. The lower valuation redistributes wealth from optimistic agents to the pessimistic agents (who did not purchase the asset on margin).  This redistribution of wealth can be very large depending on the leverage of the optimistic agents.  
Now if we are willing to assume that enough optimistic agents survived the fire sale (i.e., that at least some of the optimistic agents were not so levered up that they completely defaulted on their debts following the revaluation of asset prices), then these agents will find the assets that they value highly available for purchase at extremely low prices.  Now is an excellent time for then to buy.  The optimistic agents will begin to bid up the price, and voila we have the makings of a cycle!

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