Why Can Margin Requirements Increase Volatility and Benefit Margin Constrained Investors?

We propose a tractable equilibrium model to examine how margin requirements affect asset prices, market volatility, and market participants’ welfare. We show that margin requirements can have opposite effects on market volatility when they constrain different investors and thus can help explain why empirical results have been mixed. Contrary to one of the main regulatory goals, we find that even though margin requirements restrict borrowing and shorting, they can significantly increase market volatility. In addition, margin requirements can make margin constrained investors better off and can lead to a greater return reversal. Our analysis also provides new empirically testable implications.