Informed Trading, Forced Trades and Amplification Mechanisms

We analyze non-fundamental asset price deviations and their evolutions, and propose a rational, information-based explanation to them when traders are exposed to forced-trades (e.g. fire-sales, fire-purchases). The first objective of this study is to provide a generalized, information-based framework for examining various types of asset price deviations stemming from traders' funding constraints. We do so within an information-setting that allows a second dimension of uncertainty (in the fraction of forced-trades, in addition to the one in the asset value). Second, using this framework, our study explains persistent price deviations (e.g. crashes) following high-leverage periods, by dynamically modeling the mechanism producing the forced-trades via margin trading (a common way for making use of readily available leverage), where margin calls arise due to adverse price changes over time. Our model predicts under-(over-) shooting in the prices when the fraction of unobserved firesales is initially under-(over-) estimated by the market maker. Next, we demonstrate within the dynamic margin trading set-up that, when the constrained traders are the informed traders, rather than the uninformed traders, then due to an informational positive feedback mechanism the mispricing exhibits persistence, as opposed to reversal (correction). Note that, two key elements for better understanding systemic risk, namely the endogenous risk and amplification mechanisms, play together an important role in our study. Finally, we discuss policy issues that could mitigate the destabilizing effects of forced trades