Leverage and Market Stability : The Role of Margin Rules and Price Limits

We show that when some investors hold levered portfolios by engaging in margin borrowing, repeated rounds of trading can result in market instability--in the sense that prices can move rationally--even in the absence of any change in fundamentals. We show this with a simple model in which all agents are rational and symmetrically informed. We discuss welfare implications of price stability and explore the effects of market composition and market trading rules on the stability of the market. A major result of this article is that price limits might enhance market stability by excluding potentially destabilizing market prices