NATIONAL BUREAU OF ECONOMIC RESEARCH
NATIONAL BUREAU OF ECONOMIC RESEARCH

"Overreaction" of Asset Prices in General Equilibrium

S. Rao Aiyagari, Mark Gertler

NBER Working Paper No. 6747
Issued in October 1998
NBER Program(s):   AP

We attempt to explain the overreaction of asset prices to movements in short-term interest rates, dividends, and asset supplies. The key element of our explanation is a margin constraint that traders face which limits their leverage to a fraction of the value of their assets. Traders may lever themselves further, either directly by borrowing short term or indirectly by engaging in futures and options trading, so that the scenario is relevant to contemporary financial markets. When some shock pushes asset prices to a low enough level at which the margin constraint binds, traders are forced to liquidate assets. This drives asset prices below what they would be with frictionless markets. Also, a shock which simply increases the likelihood that the margin constraint will bind can have a very similar effect on asset prices. We construct a general equilibrium model with margin constrained traders and derive some qualitative properties of asset prices. We present an analytical solution for a deterministic version of the model and a simple numerical computation of the stochastic version.

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Document Object Identifier (DOI): 10.3386/w6747

Published: Review of Economic Dynamics, Vol. 2, no. 1 (January 1999): 3-35 citation courtesy of

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