Bubbles and Leverage

Campbell, Gareth (2010): Bubbles and Leverage.

Abstract

This paper analyses the relationship between leverage and asset price bubbles. During an important historical bubble there was a substantial expansion in the number of railways promoted, most of which were financed by shares which could be purchased on an instalment basis. An analysis of a new and comprehensive dataset suggests that these assets can be modelled as futures or options, implying that investors were purchasing highly leveraged derivatives. The leverage embedded in these assets amplified returns and made it possible to obtain exposure to an asset for a small deposit. However, during the downturn negative returns were also magnified and investors had difficulties paying further instalments. Although leverage may have initially increased demand for these assets, they did not become overpriced, possibly due to a substantial increase in their supply.

• Item Type: MPRA Paper
• Language: English
• Keywords: bubbles, financial crises
• Subjects: G - Financial Economics > G1 - General Financial Markets > G12 - Asset Pricing ; Trading Volume ; Bond Interest Rates; N - Economic History > N2 - Financial Markets and Institutions > N23 - Europe: Pre-1913; G - Financial Economics > G1 - General Financial Markets > G13 - Contingent Pricing ; Futures Pricing; G - Financial Economics > G0 - General > G01 - Financial Crises

References

Allen, F. & Gale, D. (1997), ‘Bubbles and Crises’, The Economic Journal, vol. 110(460), pp. 236-55.

Aoki, K., Proudman, J., and Vlieghe, G. (2002). ‘Houses as Collateral: Has the Link between House Prices and Consumption in the U.K. Changed?’, Economic Policy Review, Federal Reserve Bank of New York, May, pp. 163-77

Bernanke, B.S., and Gertler, M. (2001). 'Should Central Banks Respond to Movements in Asset Prices?' American Economic Review, vol. 91 (May), pp. 253-57.

Black, F. & Scholes, M. (1973), ‘The Pricing of Options and Corporate Liabilities’, Journal of Political Economy, vol. 81, no. 3, pp. 637.

Campbell, G. (2010), “Cross-Section of a ‘Bubble’: Stock Prices and Dividends during the British Railway Mania”, SSRN Working Paper.

Campbell, G. and Turner, J. (2010), “‘The Greatest Bubble in History’: Stock Prices during the British Railway Mania”, SSRN Working Paper.

Course of the Exchange (1843-50).

Dale, R., Johnson, J.E.V. & Tang, L. (2005), ‘Financial Markets can Go Mad: Evidence of Irrational Behaviour during the South Sea Bubble’, Economic History Review, vol. 58, no. 2, pp. 233-271.

Detken, C. and Smets, F. (2004), 'Asset Price Booms and Monetary Policy', ECB Working Paper no. 364. Economist (1843-50).

Engle, R. F. and Granger, C.W.J. (1987), ‘Co-Integration and Error Correction: Representation, Estimation, and Testing’, Econometrica, vol. 55, pp.251-276.

Foote, C.L., Gerardi, K. & Willen, P.S. (2008), ‘Negative Equity and Foreclosure: Theory and evidence’, Journal of Urban Economics, vol. 64(2), pp. 234-245.

Froot, K.A. & Dabora, E.M. (1999), ‘How are Stocks Affected by the Location of Trade?’, Journal of Financial Economics, vol. 53, pp. 189-216.

Guiso, L., Sapienza, P. & Zingales, L. (2009), ‘Moral and Social Constraints to Strategic Default on Mortgages’, CEPR Working Paper.

Hull, J. (2003), Options, Futures, and other Derivatives, Pearson Prentice Hall.

Jackman, W.T. (1966), The Development of Transportation in Modern England, Cass.

Johansen, S. (1988), ‘Statistical Analysis Of Cointegration Vectors’, Journal of Economic Dynamics and Control, vol. 12, no. 2-3, pp. 231-254.

Kindleberger, C.P. (2000), Manias, Panics, and Crashes: A History of Financial Crises, John Wiley & Sons.

Lamont, O.A. & Thaler, R.H. (2003), ‘Can the Market Add and Subtract? Mispricing in Tech Stock Carve-outs’, Journal of Political Economy, vol. 111, no. 2, pp. 227-268.

Lewin, H.G. (1968), The Railway Mania and its Aftermath, 1845-1852 (Being a Sequel to Early British Railways), Rev. Edn, A. M. Kelley.

MacDermot, E.T. (1964), History of the Great Western Railway, Ian Allan Ltd.

Mitchell, B.R. (1964), ‘The Coming of the Railway and United Kingdom Economic Growth’, Journal of Economic History, vol. 24, no. 3, pp. 315-336.

Murphy, A.L. (2009), ‘Trading Options before Black-Scholes: A Study of the Market in Late Seventeenth Century London’, Economic History Review, vol. 62, no. S1, pp. 8-30.

Nairn, A. (2002), Engines that Move Markets: Technology Investing from Railroads to the Internet and Beyond, Wiley.

Parliamentary Papers (1847-48), LXIII, p.275-442 ‘Return of the names of railways for which acts have been obtained; calls made; amount received and remaining due; sums borrowed which remain owing; balance of capital uncalled for, and of money which the companies retain power to borrow; and, periods for which the companies have postponed making further calls.’

Parliamentary Papers (1847-48), VIII, Pt. I, p.1, ‘Reports from the Secret Committee on Commercial Distress; with an Index’.

Pollins, H. (1971), Britain's Railways: An Industrial History, David and Charles (Publishers) Limited. Railway Times (1843-50).

Shea, G.S. (2007a), ‘Understanding Financial Derivatives During the South Sea Bubble: The Case of the South Sea Subscription Shares’, Oxford Economic Papers, vol. 59, no. Supplement 1, pp. i73.

Shea, G.S. (2007b), ‘Financial Market Analysis Can Go Mad (in the Search for Irrational Behaviour During the South Sea Bubble)’, Economic History Review, vol. 60, no. 4, pp. 742-765.

Simmons, J. (1978), The Railway in England and Wales, 1830-1914, vol.1, Leicester University Press.

Stock, J.H. & Watson, M.W. (2003), Introduction to Econometrics, Addison Wesley.

The Railway Investment Guide. How to Make Money in Railway Shares: A Series of Hints and Advice to Parties Speculating (1845).

The Times (1843-50).

Tuck, H. (1845), The Railway Shareholder's Manual; Or Practical Guide to All the Railways in the World, Sixth Edition, Effingham Wilson.

Tuck, H. (1848), The Railway Shareholder's Manual; Or Practical Guide to All the Railways in the World, Eighth Edition, Effingham Wilson.