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RFS Advance Access published online on May 7, 2008
Review of Financial Studies, doi:10.1093/rfs/hhn045
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© The Author 2008. Published by Oxford University Press on behalf of The Society for Financial Studies. All rights reserved. For Permissions, please e-mail: journals.permissions@oxfordjournals.org.

Margin Trading, Overpricing, and Synchronization Risk

Sanjeev Bhojraj
S.C. Johnson Graduate School of Management, Cornell University

Robert J. Bloomfield
S.C. Johnson Graduate School of Management, Cornell University

William B. Tayler
Goizueta Business School, Emory University

Address correspondence to Sanjeev Bhojraj at Cornell University, SC. Johnson Graduate School of Management, Cornell University, Ithaca, NY 14853, telephone: (607) 255-4069, or email: sb235@cornell.edu; Robert J. Bloomfield at Cornell University, SC Johnson Graduate School of Management, Cornell University, Ithaca, NY 14853, telephone: (607) 255-9407, or email: rjb9{at}cornell.edu; or William B. Tayler can be reached at Emory University, Goizueta Business School, 1300 Clifton Road NE, Atlanta, Georgia 30322, telephone: (404) 727-2362, or email william_tayler{at}bus.emory.edu.

JEL Classification: G14, C92


  Abstract

We provide experimental evidence that relaxing margin restrictions to allow more short selling can exacerbate overpricing, even though it reduces equilibrium price levels. This is because smart-money traders initially profit more by front-running optimistic investor sentiment than by disciplining prices. When short selling is not possible, competitive pressures among arbitrageurs rapidly drive prices to the equilibrium. However, the risk of margin calls slows the convergence process, because arbitrageurs who sell short too early face substantial losses if they are unable to synchronize their trades with other arbitrageurs (as in Abreu and Brunnermeier. 2002. Journal of Financial Economics 66(2–3):341–60; 2003. Econometrica 71(1):173–204).

We thank workshop participants at Pennsylvania State University, Harvard Business School, and CRA International for comments, and Cornell's Johnson Graduate School of Management and Emory's Goizueta Business School for financial support.


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