Heterogeneous Beliefs, Short Sale Constraints, Deleveraging, and Stock Market Crashes

Abstract

This paper develops a theory of market crashes resulting from an unanticipated deleveraging shock. We consider two groups of representative investors in a market holding different opinions about the public available information. The unexpected deleveraging shock forces the high confidence investors to liquidate their risky assets to pay back their margin loans. This creates a liquidity shortage in which asset prices have to fall substantially to restore trades when short sales are restricted ex ante. The deleveraging process also generates further price decline as low confidence investors absorb the liquidated assets. On top of these, the presence of multiple risky assets introduces substantial spillover effects, precipitating the crash. By comparing with the return data from the Chinese stock market during its recent crash, our models can fit quite well qualitatively its cross-sectional features. Insofar as it is difficult to regulate leverage, we argue that the ex ante relaxation of short sale constraints can moderate both the excessive rise and fall of asset prices.