The existence of procyclical leverage amplifies the effect on asset prices over the business cycle.
Conventional economic theory suggests that interest rates determine the demand and supply of loans.
Therefore, in addition to interest rates, collateral requirements should also be taken into consideration in determining the demand and supply of loans.
Individual investors are not able to take advantage of these arbitrage opportunities but arbitrageurs can, due to better information and greater access to capital.
However, due to margin requirements, even arbitrageurs may potentially face financial constraints and may not be able to completely eliminate the arbitrage opportunities.
An arbitrageur who is financially constrained, in other words, has exhausted his ability to borrow externally, becomes vulnerable in an economic downturn.
The increased volatility and uncertainty can then lead to tightening margin requirements causing further forced sales of assets.
[3] In the financial crisis of 1998, many hedge funds that were engaged in arbitrage strategies experienced heavy losses and had to scale down their positions.
These events raised concerns about market disruption and systemic risk, and prompted the Federal Reserve to coordinate the rescue of Long Term Capital Management.
[3] Broadly speaking market-making arbitrageurs can hold net long positions and as a result capital constraints are more likely to be hit during market downturns.
[3] Large fluctuations in asset prices in the leverage cycle lead to a huge redistribution of wealth and change in inequality.
However, since they were primarily borne by levered financial institutions, spiral effects amplified the crisis so the stock market losses amounted to more than 8 trillion dollars.
Also during this crisis, a number of real estate properties went “under water”, in other words, the promise to repay exceeded the value of the collateral.
[2] The highly leveraged arbitrageurs are only concerned about maximizing their own objectives (e.g.: profits) and do not take into consideration the effect their decisions have on asset prices.
[1] A financially constrained firm may need to sell assets substantially below fundamental value due to margin requirements in an industry downturn.