Academic journal article East Asian Economic Review

The Effect of Initial Margin on Long-Run and Short-Run Volatilities in Japan*

Academic journal article East Asian Economic Review

The Effect of Initial Margin on Long-Run and Short-Run Volatilities in Japan*

Article excerpt

(ProQuest: ... denotes formulae omitted.)

I. Introduction

Do margin requirements play an important role in reducing stock market volatility? Many government regulators of the stock markets thought that volatility in the stock market might be controlled by some restrictions about buying on margin and short-selling. In other words, margin and short-selling can be easily used to stimulate the stock prices when the stock market is in recession, while these policies can be adopted to reduce the bubble of the stock prices when it is in boom.

Initial margin requirements were firstly imposed by the US Congress with the Securities and Exchange Act of 1934 to reduce the credit-financed speculation in the stock market, which may lead to excessive price volatility through a "pyramiding-depyramiding" process1 (Garbade, 1982). Therefore, initial margin requirements are designed and adopted to prevent excess volatility in the stock markets. However, the previous literatures show mixed results. For example, some studies (Kupiec, 1989; Hardouvelis, 1990, Hardouvelis and Theodossiu, 2002 among others) find the negative relationship between margin requirements and stock volatility, while the other studies (Schwert, 1989; Hsieh and Miller, 1990; Kim and Oppenheimer, 2002 among others) find no reliable evidence.

Basically, the pyramiding-depyramiding process takes for granted the presence of both rational and irrational investors (speculators) and expects the negative relationship between margin requirement and stock volatility. DeLong, Shleifer, Summers and Waldman (1990) theoretically show that the amount of nonfundamental volatility in the stock market increases, when noise (destabilizing) traders lever their positions. Therefore, higher margin requirements primarily restrict the participation of irrational investors in the stock market and settle excess volatilities and mispricing. Kumar et al. (1991) refer to this as the speculative effect.

Along with the speculative effect, Kumar et al. (1991) also mentioned the liquidity effect. If speculation is inherently stabilizing, then higher margin requirements restrict the activities of rational investors. That is, higher margins could potentially generate the lack of liquidity in the stock market. This lack of liquidity would cause higher volatility. This implies that when the liquidity effect prevails, there could be a positive relationship between margin requirement and stock volatility.

Depending on which effect between the speculative effect and the liquidity effect is dominant, the positive or negative relationship can be observed. In other words, if irrational (rational) investors play a role in the stock market, we can observe the negative (positive) relationship. It is natural that irrational investors play an important role in the short-run than in the long-run because sufficient time is given to collect information over the long-run. Therefore, we expect that dividing volatility into long-run and short-run components gives more insights for the effect of initial margin requirements.

The purpose of this paper is to examine the effect of initial margin requirements on long-run and short-run volatilities in the Japanese stock market. To consider the effect of initial margin requirement on long-run volatilities, the previous literatures (e.g., Hardouvelis, 1990; Hsieh and Miller, 1990; Hardouvelis and Theodossiu, 2002) construct longer horizon volatilities such as monthly and annual volatilities to examine the relationship between margin requirements and stock volatility. When using longer horizon volatilities, the relationship may be unreliable due to a handful of independent observations from generating long horizon volatilities. In the study of Hardouvelis (1990), he constructs the rolling 12-month estimator of volatility by implicitly assuming that volatility is nonstationary.2 Considering this problem, we adopt the component GARCH (CGARCH) model,3 proposed by Engle and Lee (1999). …

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