Financial leverage and market volatility with diverse beliefs

We study a general equilibrium model of asset trading with financial leverage, where the investors can engage in speculative trading with diverse beliefs about the asset’s fundamental value. We show that an increase in the leverage ratio causes the stock price to rise in the current period through a “leverage effect”, and will result in more borrowing and more stock purchase that pumps the stock price higher in the subsequent period, known as the “pyramiding effect”. There can also be a “depyramiding effect” when the price falls because lenders issue margin calls and force stock sales, contributing to further stock price plummeting. Price changes from depyramiding effect, however, may not take effect when margin calls are not triggered. We demonstrate that, under certain conditions, decreasing leverage ratios leads to lower stock price volatility, measured by the variation of prices caused by an exogenous shock, when the shock is unanticipated. The influences of dispersion of beliefs and available investment funds on the relation between financial leverage and market volatility are also examined. When the shock is anticipated, we demonstrate that reducing leverage ratios may not lower stock price volatility, which poses an important challenge to future studies on this issue.