Margin Lending and Stock Market Volatility

by Peter Fortune
Issue Number 3 — 2001

Margin loans have long been associated in the popular mind with instability in security markets, and the potential for margin lending to exacerbate the amplitude of cycles in stock prices has received considerable attention in the years since the Crash of 1929. Despite the many empirical studies of the association between margin loans or margin requirements and the volatility of stock returns, there has been no definitive answer, and the consensus among financial economists is that margin lending plays little, if any, role in shaping the probability distribution of returns on common stocks. Perhaps as a result of this, the Federal Reserve System's margin requirements have not been changed since 1974.

This study addresses the role of margin requirements from the vantage points of economic theory and the historical record. The author reviews many of the key empirical studies of the link between margin requirements and stock prices. Economic theory suggests many reasons that the link might be weak, and this is supported by many of the empirical studies.

The author estimates a model of the returns on common stocks in the period 1975-2001. The model includes information on the amount of margin debt outstanding. He concludes that margin loans are a statistically significant factor in the determination of stock returns, and that the effect is stronger and more reliable for the NASDAQ Composite index than for the S&P 500 index. However, the economic significance of margin debt is so low that this study is not able to support a return to the active margin policy that existed prior to 1974.

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