Speculation and Leverage

Speculative episodes typically involve leverage. For example, the well known tulipmania episode was accompanied by the introduction of foward contracts which allowed speculators to take leveraged positions in tulip bulbs. More recently, the Great Crash of 1929 was exacerbated by leveraged trusts which used leverage to buy stocks. These leveraged trusts could in turn be bought on margin which allowed speculators to hold highly leveraged positions. More recently, speculation in the housing market was accompanied by extreme leverage. In this paper, I provide an extension of the Harrison-Kreps(1978) speculative model but require the market for borrowing to clear. Clearing the market for borrowing provides endogenous margin requirements which limit borrowing. In addition, the wealth distribution of speculators now becomes a determinant of speculative premia and a fairly rich set of speculative dynamics arise. Tel.: +1-301-405-2063. E-mail address: [email protected]. This paper has benefited from the comments from Tao Li and seminar participants at Southwest University of Finance and Economics IFS, Hong Kong University of Science and Technology, Singapore Management University, and City University of Hong Kong. All errors are the responsibility of the author.