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Adaptive Expectations and Stock Market Crashes

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  • Frankel, David M.
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    Abstract

    A theory is developed that explains how stocks can crash without fundamental news and why crashes are more common than frenzies. A crash occurs via the interaction of rational and naive investors. Naive traders believe that prices follow a random walk with serially correlated volatility. Their expectations of future volatility are formed adaptively. When the market crashes, naive traders sell stock in response to the apparent increase in volatility. Since rational traders are risk averse as well, a lower price is needed to clear the market: the crash is a self-fulfilling prophecy. Frenzies cannot occur in this model.

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    File URL: http://econ2.econ.iastate.edu/faculty/frankel/crashrt14.pdf
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    Bibliographic Info

    Paper provided by Iowa State University, Department of Economics in its series Staff General Research Papers with number 31688.

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    Date of creation: 01 May 2008
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    Publication status: Published in International Economic Review, May 2008, vol. 49 no. 2, pp. 595-619
    Handle: RePEc:isu:genres:31688

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    Postal: Iowa State University, Dept. of Economics, 260 Heady Hall, Ames, IA 50011-1070
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    Web page: http://www.econ.iastate.edu
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    1. Harrison Hong & Jeremy C. Stein, 2003. "Differences of Opinion, Short-Sales Constraints, and Market Crashes," Review of Financial Studies, Society for Financial Studies, vol. 16(2), pages 487-525.
    2. Caplin, A. & Leahy, J., 1992. "Business as Usual, Market Crashes, and Wisdom after the Fact," Harvard Institute of Economic Research Working Papers 1594, Harvard - Institute of Economic Research.
    3. Grether, David M., . "Bayes Rule as a Descriptive Model: The Representativeness Heuristic," Working Papers 245, California Institute of Technology, Division of the Humanities and Social Sciences.
    4. Robert S. Pindyck, 1983. "Risk, Inflation, and the Stock Market," NBER Working Papers 1186, National Bureau of Economic Research, Inc.
    5. Tim Bollerslev, 1986. "Generalized autoregressive conditional heteroskedasticity," EERI Research Paper Series EERI RP 1986/01, Economics and Econometrics Research Institute (EERI), Brussels.
    6. Robert J. Shiller, 1998. "Human Behavior and the Efficiency of the Financial System," Cowles Foundation Discussion Papers 1172, Cowles Foundation for Research in Economics, Yale University.
    7. Barlevy, Gadi & Veronesi, Pietro, 2003. "Rational panics and stock market crashes," Journal of Economic Theory, Elsevier, vol. 110(2), pages 234-263, June.
    8. Chou, Ray Yeutien, 1988. "Volatility Persistence and Stock Valuations: Some Empirical Evidence Using Garch," Journal of Applied Econometrics, John Wiley & Sons, Ltd., vol. 3(4), pages 279-94, October-D.
    9. Jackwerth, Jens Carsten & Rubinstein, Mark, 1996. " Recovering Probability Distributions from Option Prices," Journal of Finance, American Finance Association, vol. 51(5), pages 1611-32, December.
    10. Markus K Brunnermeier, 2002. "Bubbles and Crashes," FMG Discussion Papers dp401, Financial Markets Group.
    11. French, Kenneth R. & Schwert, G. William & Stambaugh, Robert F., 1987. "Expected stock returns and volatility," Journal of Financial Economics, Elsevier, vol. 19(1), pages 3-29, September.
    12. Benoit Mandelbrot, 1963. "The Variation of Certain Speculative Prices," The Journal of Business, University of Chicago Press, vol. 36, pages 394.
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    Cited by:
    1. Nikolaos Antonakakis & Johann Scharler, 2012. "Volatility, Information And Stock Market Crashes," Journal of Advanced Studies in Finance, ASERS Publishing, vol. 0(1), pages 49-67, June.

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