Why Can Margin Requirements Increase Volatility and Benefit Margin Constrained Investors?

Abstract

Margin requirements have long been implemented in almost all financial markets and are often used as an important regulatory tool for improving market conditions. However, their economic impact beyond affecting default risk is still largely unknown. We propose a tractable and flexible equilibrium model to examine how margin requirements on both long and short stock positions affect asset prices, market volatility, market liquidity and market participants' welfare. Unlike the existing literature, all investors are subject to margin requirements in our model. This difference yields important new insights about the impact of margin requirements. Most of our main results are obtained in closed-form. Contrary to one of the main regulatory goals, we find that even though margin requirements restrict borrowing and shorting, they can significantly increase market volatility. In addition, margin requirements can reduce market liquidity (as measured by price impact) and lead to a greater return reversal. Moreover, margin requirements can make margin constrained investors better off. Our analysis also provides new empirically testable implications.