Financial Leverage and Market Volatility with Diverse Beliefs

We develop a model of asset trading with financial leverage in an economy with a continuum of investors. The investors are assumed to have diverse and rational beliefs in the sense of being compatible with observed data. We show that a reduction in the margin requirement may cause the stock price to rise in the current period because it increases the demand of optimistic investors through a “leverage effect”, and will result in “pyramiding” and “depyramiding” phenomena for stock prices in the subsequent period. Our results also suggest that a reduction in the margin requirement is anticipated to result in an increase in price volatility as well, however, under certain conditions. Price changes from pyramiding effect are also negatively associated with margin requirements. Price changes from depyramiding effect, however, may not be affected when margin calls are not triggered. Furthermore, the influences of dispersion of opinion, belief structure and investment funds are also examined.