Margin Calls, Trading Costs, and Asset Prices in Emerging Markets: The Finanical Mechanics of the 'Sudden Stop' Phenomenon

54 Pages Posted: 19 Oct 2002 Last revised: 18 May 2022

See all articles by Enrique G. Mendoza

Enrique G. Mendoza

National Bureau of Economic Research (NBER); University of Pennsylvania

Katherine A. Smith

U.S. Naval Academy

Date Written: October 2002

Abstract

A central feature of emerging markets crises is the Sudden Stop' phenomenon characterized by large reversals of capital inflows and current accounts, deep recessions, and collapses in asset prices. This paper proposes an open-economy asset-pricing model with financial frictions that yields predictions in line with these observations. Margin requirements and information costs distort asset trading between a small open economy and foreign securities firms. If the economy's debt-equity ratio is low, standard productivity shocks cause normal recessions with smooth current-account adjustments. If the ratio is high, the same productivity shocks trigger margin calls forcing domestic agents to firesell equity to foreign traders who are slow to adjust their portfolios. This sets off a Fisherian asset-price deflation and subsequent rounds of margin calls. A current account reversal and a collapse in consumption occur if the fire-sale of assets cannot prevent a sharp increase in net foreign asset holdings.

Suggested Citation

Mendoza, Enrique G. and Smith, Katherine A., Margin Calls, Trading Costs, and Asset Prices in Emerging Markets: The Finanical Mechanics of the 'Sudden Stop' Phenomenon (October 2002). NBER Working Paper No. w9286, Available at SSRN: https://ssrn.com/abstract=341854

Enrique G. Mendoza (Contact Author)

National Bureau of Economic Research (NBER) ( email )

1050 Massachusetts Avenue
Cambridge, MA 02138
United States

University of Pennsylvania ( email )

Philadelphia, PA 19104
United States

HOME PAGE: http://www.sas.upenn.edu/~egme/index.html

Katherine A. Smith

U.S. Naval Academy ( email )

121 Blake Road
Annapolis, MD 21402-5000
United States

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