“Leverage and Asset Prices: An Experiment”: A new paper from the Federal Reserve Bank of New York

A Staff Paper was just released by the Federal Reserve Bank of New York with the auspicious title “Leverage and Asset Prices: An Experiment”. The authors are Marco Cipriani, Ana Fostel, and Daniel Houser. The paper theorizes that assets where there is leverage available will trade at higher prices than if leverage is not possible. The paper sets up a theoretical framework and then describes an experiment the authors did on willing subjects (in this case, college students at the Interdisciplinary Center for Economic Science (ICES) at George Mason University).

It should come as no surprise to anyone involved in securities financing that theory predicts leverage increases asset values. Driving price is not only investment value of an asset, but also the collateral value. This implies that there are two prices for assets that have identical payoffs, but different values as collateral.

In a nod to practical application of the theory, the authors cited a paper by Forstel and Geanakoplos (2008) “When the crisis hits, assets that can be used as collateral see their prices drop by less than assets that cannot”.

The paper is technical with a large dose of academic repartee thrown in. But the fundamental message is worth understanding: when you add the ability to leverage an asset, its equilibrium price will be higher than without the leverage.

A link to the paper is here.

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