Leveraged Speculators and Asset Prices

Leveraged speculators and asset prices
Wenxi Jiang
Review of Finance, Volume 28, Issue 3, May 2024, Pages 769–804, https://doi.org/10.1093/rof/rfad037

From the episode of the Long-Term Capital Management (LTCM) in 1998 to the stock market crashes in 1929 and 1987, the quant crisis in 2007, the financial crisis in 2007-2008, and the bond market turmoil in 2020, there is ample anecdotal evidence suggesting that excessive leverage used by speculators can greatly amplify market crashes.  In the paper, I provide systematic evidence on how the use of leverage by market speculators can increase the likelihood and severity of crashes in stock prices.  

I first develop a direct measure of U.S. hedge fund leverage based on mandatory regulatory filings to the SEC.  I find that while the average hedge fund leverage is modest around 2, the distribution is positively skewed: a small fraction of hedge funds, like LTCM, are taking an extremely high level of leverage that generates fragility in the market.  I further show that hedge fund leverage can be well explained by the funds’ portfolio diversification level and turnover with a R-square of 48%.  

Leveraged hedge funds are vulnerable to negative shocks and tend to experience fire sales, because of margin calls or specific risk management practices, such as stop-loss orders.  Such selling can generate downward pressure on the prices of stocks being liquidated, inducing further selling and a downward spiral in prices that ends with a crash.  

By linking hedge funds’ leverage to their equity holdings in 13F, I show several findings that are supportive to the leverage-induced fire-sale mechanism. First, I find that stocks held by highly leveraged hedge funds subsequently have more negatively skewed returns than stocks held by less leveraged funds.  Such finding is robust to a dozen of alternative measures on crash risk or left-tail volatility of stock prices. Moreover, upon extremely negative earnings surprises or funding liquidity shocks, stocks owned by high-leverage funds tend to exhibit abnormal price declines that are subsequently reversed. Also, consistent with the price pattern, high-leverage funds indeed reduce the position following negative news about a stock.  Last but not least, such selling can be contagious, spillovering to other stocks in the fund’s portfolio and increasing the crash-proneness of the stocks it holds.

The hedge fund leverage data developed in this paper is available to download from the author’s website.

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