By Yang Xuewei, professor at the School of Engineering Management, Nanjing University, and deputy director of the Financial Engineering Research Center of Nanjing University. The paper "Leverage Is a Double-Edged Sword" was co-authored by Professor Avanidhar Subrahmanyam of the University of California Anderson School of Management, Professor Tang Ke of the School of Social Sciences of Tsinghua University, Professor Wang Jingyuan of the School of Economics and Management of Beihang University, and Professor Yang Xuewei of the School of Engineering Management of Nanjing University. Journal of Finance.
On the one hand, leverage provides investors with the opportunity to magnify their profits, but on the other hand, it can also increase the risk of investors falling into financial difficulties. The paper "Leverage Is a Double-Edged Sword" uses desensitized account data from China's futures market to delve into the interaction between investor ability, leverage and performance, and makes important progress in the mechanism of leverage affecting investment performance.
As an important mechanism of the modern financial system, leverage (by borrowing funds to invest or achieve early consumption) has a profound impact on all aspects of modern economic production and life. The company expands production and creates profits through leveraged operation, families realize early consumption through leveraged house purchases and car purchases, and investors in the financial market increase leverage in order to increase investment returns. The existing literature systematically studies the dynamic changes of leverage and its impact on corporate operating performance and operational risk, discusses the relationship between household leverage and investment, consumption and economic cycles, and the impact of leverage on asset price dynamics and market operation quality. However, there is not enough research in academia on the impact of leverage on investor behavior and performance.
In the field of financial investment, the essence of leverage is to use small to broaden, that is, to leverage a larger amount of assets with a small amount of money. In the financial markets, there are at least three ways in which leverage can be generated. One way is to trade in the stock market: buy more assets with funds through a brokerage. In this way, the investor needs to pay financing interest to the brokerage, and the corresponding leverage ratio is 2 to 3 times, that is, the amount of funds that the investor can borrow from the brokerage is 1 to 2 times the total value of the account's own assets. The second way is to buy options. According to classical financial engineering theory, buying a call option is essentially equivalent to buying the underlying asset by borrowing funds, and buying a call option can provide 10 to 30 times leverage, and in some extreme cases, it can even provide up to 1,000 times leverage (the mainland options market has seen a single-day increase of more than 100 times, while the price of the underlying asset has increased by less than 10% in the same period). The third way is to trade futures. Leverage in the futures market is generated by margin trading: futures investors are usually not required to pay the full amount of their assets, but only to pay a certain percentage of the margin. If the minimum margin ratio of a futures product is 8%, the maximum leverage provided by the product is 12.5 (=1/0.08) times. The level of leverage in the futures market is related to the volatility of the underlying asset: in the case of short-term treasury bonds with low price fluctuations, the minimum margin in the corresponding futures market can be less than 1%, so the leverage level can exceed 100 times.
While it is true that leverage provides investors with the opportunity to magnify their profits, losses triggered by leveraged trading can also put investors in financial trouble. For example, during the abnormal volatility of China's A-shares in 2015, a large number of leveraged investors (including on-exchange financing and over-the-counter allocation) were forced to liquidate their positions due to large losses and inability to replenish funds in a timely manner. In April 2021, Bloomberg Businessweek reported that Archegos Capital Management lost $20 billion in two trading days due to leveraged trading. A number of historical cases, including the collapse of the Long-Term Capital Management Company (LTCM) and the bankruptcy of Barings Bank, show that even professional investors can go bankrupt due to excessive use of leverage. Warren Buffett, a well-known investor and "god of stocks", has repeatedly emphasized that it is very dangerous to increase leverage in investment. In recent years, warnings that investors should avoid leveraged trading have been in the news, although the media has occasionally reported success stories [in December 2020, the Wall Street Journal wrote that retail investor Bruce Burnworth made nearly $2 million on a $23,000 call option on Tesla stock that he bought at the beginning of the year].
How does leverage affect investors' trading behavior and performance? Specifically, can investors obtain excess returns by increasing leverage? What is the mechanism of leverage affecting investors' performance? What is the role of the forced liquidation system? How does investor behavior deviation affect the trading behavior and performance of leveraged investors? How does the regulation of leverage level affect investor behavior and investment performance? Avanidhar Subrahman of the University of California Anderson School of Management Professor Subrahmanyam, Professor Tang Ke from the School of Social Sciences at Tsinghua University, Professor Wang Jingyuan from the School of Economics and Management at Beihang University, and Professor Yang Xuewei from the School of Engineering Management at Nanjing University co-authored the paper "Leverage Is a Double-Edged Sword" (hereinafter referred to as the "paper") using desensitized account data from China's futures market to study the above problems. The paper points out that there is a negative correlation between investors' leverage levels and investment performance, partly due to increased transaction costs due to leverage, and partly due to liquidity costs caused by forced liquidation. The paper was published in the Journal of Finance, a top journal in international finance.
The original data of the paper is the desensitized account data of 10,822 investors in China's futures market from January 2, 2014 to December 30, 2016 (a total of 733 trading days) provided by a futures brokerage company, and the sample includes 39.4 million transaction records (including physical delivery records). The final sample used in the paper was data from 10,507 individual investors (previous studies found that the impact of leverage on the performance of 315 institutional investors was not significantly different from its impact on individual investors). The dataset covers 51 futures varieties with a total of 1,086 futures contracts (as can be seen from the China Securities and Futures Market Yearbook, there are 51 futures varieties in the China futures market during the same period, with a total of 1,842 futures contracts listed and traded). The futures investors involved in this paper are quite different from the retail investors in the stock market involved in the previous literature. From the perspective of turnover rate, the monthly turnover rate of domestic and foreign stock market investors generally does not exceed 100%, while the median daily turnover rate of futures market investors reported in the paper exceeds 400%. From investment experience, recent research on users of the American internet brokerage Robinhood shows that most of them are "newbies". According to China's futures market access standards, futures market investors need to have certain investment experience and relatively strong financial strength......
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Article source丨Tsinghua Financial Review, Issue 125, April 2024
This article is edited by Zhou Mingyi
Editor-in-charge丨Ding Kaiyan, Lan Yinfan
Preliminary trial丨Xu Lanying
Final Review丨Zhang Wei
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