Surge in return correlation means a deterioration in investment opportunities in that it may reduce diversification benefits and impose excessively large leverage on the optimal portfolios of agents. Correlation-driven leverage triggers large trades without any informational reason or any contagion. Since unanticipated payoff shocks are fed into the initial wealth in the coming periods, correlation-driven trades amplify them into huge endowment shocks. Remarkably, small payoff shocks can cause market breakdown when correlationdriven leverage prevails. Correlation surge can lead rather than follow market crisis. The paper presents a simple form of credit limits on the ex-dividend capital values of portfolios which are designed to prevent the correlation-driven excessive leverage of optimal portfolios in stochastic finance models. It is illustrated that tighter discretionary credit limits can lead to Pareto improvement when they create an advantageous tradeoff between diversification benefits and risk-sharing opportunities by reducing payoff correlation. Remarkably, conventional borrowing constraints which aim at preventing doubling strategies or Ponzi schemes may fail to restrain correlation-driven leverage. Thus, they are not effective in preventing market crashes which are attributed to the correlation-amplified income shocks.
KEYWORDS: Correlation-driven trades, similar assets, discretionary credit limits, unanticipated payoff shocks, general equilibrium, incomplete asset markets.
JEL Classification: D52, C62, C63, C02
