Long Run Feedback in the Broker Call Money Market

TL;DR

This paper models the long-term dynamics of the broker call money market, showing how leverage, interest rates, and market growth interact, leading to convergence of leverage and wealth ratios over time.

Contribution

It introduces a continuous-time model of the broker call money market, revealing the asymptotic behavior of leverage, interest rates, and wealth ratios in a stochastic environment.

Findings

The relative size of the money market converges to zero.

Interest rates converge to the choke price in mean square.

Gambler's wealth ratio to buy-and-hold increases with high probability.

Abstract

I unravel the basic long run dynamics of the broker call money market, which is the pile of cash that funds margin loans to retail clients (read: continuous time Kelly gamblers). Call money is assumed to supply itself perfectly inelastically, and to continuously reinvest all principal and interest. I show that the relative size of the money market (that is, relative to the Kelly bankroll) is a martingale that nonetheless converges in probability to zero. The margin loan interest rate is a submartingale that converges in mean square to the choke price $r_\infty:=\nu-\sigma^2/2$, where $\nu$ is the asymptotic compound growth rate of the stock market and $\sigma$ is its annual volatility. In this environment, the gambler no longer beats the market asymptotically a.s. by an exponential factor (as he would under perfectly elastic supply). Rather, he beats the market asymptotically with very high probability (think 98%) by a factor (say 1.87, or 87% more final wealth) whose mean cannot exceed what the leverage ratio was at the start of the model (say, $2:1$). Although the ratio of the gambler's wealth to that of an equivalent buy-and-hold investor is a submartingale (always expected to increase), his realized compound growth rate converges in mean square to $\nu$. This happens because the equilibrium leverage ratio converges to $1:1$ in lockstep with the gradual rise of margin loan interest rates.