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Working Paper

Give ’em Enough Rope? Leveraged Trading when Investors are Overconfident

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Can leverage constraints mitigate overconfident financial decision-making? I examine CFTC regulation capping the maximum permissible leverage available to U.S. households that trade foreign exchange on the same brokerages as similar but unregulated European traders. The constraint reduces trading volume and alleviates up to three-quarters of per-trade losses. According to a model of portfolio choice with distorted beliefs, investor overconfidence can explain both leverage demand and underperformance. Several tests support the predictions of the model. Using common proxies to classify traders as overconfident, I find that these traders are most affected by the regulation. Consistent with overconfident, belief-based trading, traders ignore CFTC warnings of leveraged trading risks.
Topics
Financial markets
10.27.2015ISSN 2573-7953 WP 15-26DOI 10.26509/frbc-wp-201526

Working Papers of the Federal Reserve Bank of Cleveland are preliminary materials circulated to stimulate discussion and critical comment on research in progress. They may not have been subject to the formal editorial review accorded official Federal Reserve Bank of Cleveland publications. The views expressed in this paper are those of the authors and do not represent the views of the Federal Reserve Bank of Cleveland or the Federal Reserve System.

Suggested Citation

Heimer, Rawley Z. 2015. “Give ’em Enough Rope? Leveraged Trading when Investors are Overconfident.” Federal Reserve Bank of Cleveland, Working Paper No. 15-26. https://doi.org/10.26509/frbc-wp-201526