Convergence trading with wealth effects: An amplification mechanism in financial markets

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Abstract

I study convergence traders with logarithmic utility in a continuous-time equilibrium model. In general, convergence traders reduce asset price volatility and provide liquidity by taking risky positions against noise trading. However, when an unfavorable shock causes them to suffer capital losses, thus eroding their risk-bearing capacity, they liquidate their positions, thereby amplifying the original shock. In extreme circumstances, this wealth effect causes convergence traders to be destabilizing in that they trade in exactly the same direction as noise traders. This situation is consistent with the near-collapse of Long-Term Capital Management in 1998.

Original languageEnglish (US)
Pages (from-to)247-292
Number of pages46
JournalJournal of Financial Economics
Volume62
Issue number2
DOIs
StatePublished - Nov 1 2001

All Science Journal Classification (ASJC) codes

  • Accounting
  • Finance
  • Economics and Econometrics
  • Strategy and Management

Keywords

  • Convergence trading
  • Destabilizing speculation
  • G10
  • G20
  • LTCM crisis
  • Volatility amplification
  • Wealth effect

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