Role of Leverage in Bubbles and Crashes

Hitoshi Matsushima

No CARF-F-288, CARF F-Series from Center for Advanced Research in Finance, Faculty of Economics, The University of Tokyo

Abstract: This paper investigates the possibility that an unproductive company with limited debt capacity raises huge funds through share issuances by utilizing a small sign of enthusiasm. We generalize the timing game of Matsushima (2012) by permitting arbitrageurs to use high leverage for purchasing the shares. Thanks to this leverage, any arbitrageur has strong incentive to ride the bubble by continuing to purchase them, instead of timing the market quickly. We show that the harmful bubble persists for a long time as the unique Nash equilibrium. Importantly, this result holds even if the underlying positive feedback traders are not very enthusiastic.

Pages: 29 pages
Date: 2012-08
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Working Paper: Role of Leverage in Bubbles and Crashes (2012)
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