Changes in the amount of margin debt may reflect certain investors' behavior and may well be related to stock market movements, which should provide investors and regulators with useful information. Initial margin requirements are set by the Federal Reserve, maintenance margin requirement is determined by individual brokerage firms.
The relationship between margin borrowing and stock returns is a key issue in the literature. The "pyramid" theory as described in Bogen and Krooss (1960) argues that margin debt increases stock market volatility. In periods of rising stock markets, investors borrow more margin loans and buy more stocks in their margin accounts, inducing higher stock prices and subsequently qualifying the borrowers for additional margin loans. Reversely, when the stock markets are declining, the margin loan borrowers are forced to sell stocks following margin calls, inducing further decreases in stock prices and more subsequent sales. Yet, it is not clear whether margin debt is a cause of the stock returns or just an indicator of the market (Fortune, 2001). Domian et al. (2006) and Zhang (2005) show evidence that margin debt responds to previous stock returns rather than vice versa.
Most margin debt borrowers are believed to be individual investors or noise traders (Kofman & Moser, 2001). Past research works report an unclear causal relationship between individual investors' sentiment and stock market price (see Gervais & Odean, 2001; Brown & Cliff, 2004; Wang et al., 2006; Fisher & Statman, 2000; Baker & Wurgler, 2006). Changes in margin debt may signal investor sentiment.
Interest rates on margin debt represent the cost for margin debt. Brokerage firms set their margin debt interest rates based on call rate, which is in turn based on the prime rate. Domian and Racine (2006) find that margin borrowing is negatively related to short term interest rate. However, margin debt borrowers may not consider this cost when they borrow because they expect significant return from buying stocks and want to use the leverage.
Economic growth is a closely watched indicator by investors because economic growth is closely positively related to stock market returns, yet the timing is uncertain. Investors buy more stocks when they expect higher economic growth and sell when they expect economic declines.
In this study we further research the relationship between margin debt and stock returns. We use both regression and Granger causality tests to examine whether stock market movements lead margin debt changes, or vice versa. We also examine whether the level of interest rate on margin debt affects margin loan borrowing. Finally, we try to find whether margin loan borrowers' behavior is affected by expected macro economic growth.
The paper is organized as follows. Section 2 describes the data. Section 3 presents the empirical results, and Section 4 concludes.
Data of outstanding margin debt balances are obtained from the New York Stock Exchange (NYSE) and the NASDAQ, respectively. Only monthly data of margin debt balances are available. Data of the prime rate and GDP growth rate are from International Financial Statistics that is published by the International Monetary Fund. Since only quarterly GDP growth data is available, we convert the quarterly data into monthly data by calculating the geometric monthly average. The S&P 500, the New York Stock Exchange Composite. Russell 2000, DJIA (the Dow Jones Industrial Average), NASDAQ Composite, and NASDAQ 100 indexes are from finance.yahoo.com. The sample period is from January 1997 to September 2008 for NYSE and January 1997 to June 2007 for NASDAQ due to margin debt data availability. Summary statistics are reported in Table 1.
Following Domian and Racine (2006), we calculate the percentage changes in margin debt balances and prime rate. Most economic models imply that interest rates are stationary (Ang & Bekaert, 2001). …