Scandinavian Working Papers in Economics

Discussion Papers of Business and Economics,
University of Southern Denmark, Department of Business and Economics

No 14/2014: A Leverage-Based Measure of Financial Instability

Alexander Tepper () and Karol Jan Borowiecki ()
Additional contact information
Alexander Tepper: Federal Reserve Bank of New York, Postal: and University of Oxford
Karol Jan Borowiecki: Department of Business and Economics, Postal: University of Southern Denmark, Campusvej 55, DK-5230 Odense M, Denmark

Abstract: We employ a model of leverage-induced explosive behavior in financial markets to develop a measure of financial market instability. Specifically, we derive a quantitative condition for how large levered investors can become relative to the whole market before the demand curve for securities suddenly becomes upward-sloping and small price declines cascade as levered investors are forced to liquidate. The size and leverage of all levered investors and the elasticity of demand of unlevered investors define the minimum market size for stability (or MinMaSS), the smallest market size that can support a given group of levered investors. The ratio of actual market size to MinMaSS is termed the instability ratio, and can give regulators and policymakers advance warning of financial crises. We apply the instability ratio in an investigation of the 1998 demise of the hedge fund Long-Term Capital Management. We find that a forced liquidation of the fund threatened to destabilize some financial markets, particularly for bank funding and equity volatility.

Keywords: Leverage; financial crisis; financial stability; minimum market size for stability (MinMass); instability ratio; Long-Term Capital Management (LTCM)

JEL-codes: E58; G01; G10; G20; G21

41 pages, August 26, 2014

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