Adaptive Expectations and Stock Market Crashes
AbstractA 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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Bibliographic InfoPaper provided by Iowa State University, Department of Economics in its series Staff General Research Papers with number 31688.
Date of creation: 01 May 2008
Date of revision:
Publication status: Published in International Economic Review, May 2008, vol. 49 no. 2, pp. 595-619
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Find related papers by JEL classification:
- D03 - Microeconomics - - General - - - Behavioral Economics; Underlying Principles
- D84 - Microeconomics - - Information, Knowledge, and Uncertainty - - - Expectations; Speculations
- G01 - Financial Economics - - General - - - Financial Crises
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