Convergence trading with wealth effects: an amplification mechanism in financial markets

Abstract I study convergence traders with logarithmic utility in a continuous-time equilibrium model. In general, convergence traders reduce asset price volatility and provide liquidity by taking risky positions against noise trading. However, when an unfavorable shock causes them to suffer capital losses, thus eroding their risk-bearing capacity, they liquidate their positions, thereby amplifying the original shock. In extreme circumstances, this wealth effect causes convergence traders to be destabilizing in that they trade in exactly the same direction as noise traders. This situation is consistent with the near-collapse of Long-Term Capital Management in 1998.

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