Leverage Network and Market Contagion

Using detailed data of margin investors’ leverage ratios and trading activities, we provide novel evidence for the effect of margin-induced trading on the cross-section of stock returns during the recent market turmoil in China. We first document the deleverge-induced sales. Aggregating this behavior across margin investors, we find a significant return spillover: a stock’s return can be strongly forecasted by a portfolio of stocks with which it shares common margin investor ownership. This pattern is subsequently reversed, and is present only in market downturns. Exploiting three government bailout waves of the stock market, we provide additional evidence for the shock transmission role of, and the systematic importance of central stocks in the leverage network.