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Differences of Opinion, Rational Arbitrage and Market Crashes

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  • Harrison Hong
  • Jeremy C. Stein

Abstract

We develop a theory of stock-market crashes based on differences of opinion among investors. Because of short-sales constraints, bearish investors do not initially participate in the market and their information is not revealed in prices. However, if other, previously-bullish investors have a change of heart and bail out of market, the originally-more-bearish group may become the marginal "support buyers", and hence more will be learned about their signals. Thus accumulated hidden information tends to come out during market declines. The model helps explain a variety of stylized facts, including: 1) large movements in prices unaccompanied by significant news about fundamentals; 2) negative skewness in the distribution of market returns; and 3) increased correlation among stocks in a falling market. In addition, the model makes a distinctive out-of-sample prediction: that negative skewness will be most pronounced conditional on high trading volume.

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Bibliographic Info

Paper provided by National Bureau of Economic Research, Inc in its series NBER Working Papers with number 7376.

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Date of creation: Oct 1999
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Publication status: published as Hong, Harrison and Jeremy C. Stein. "Differences Of Opinion, Short-Sales Constraints, And Market Crashes," Review of Financial Studies, 2003, v16(2,Summer), 487-525.
Handle: RePEc:nbr:nberwo:7376

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  1. Jennifer Koski & Jeffrey Pontiff, 1996. "How Are Derivatives Used? Evidence from the Mutual Fund Industry," Center for Financial Institutions Working Papers 96-27, Wharton School Center for Financial Institutions, University of Pennsylvania.
  2. Greenwald, Bruce C & Stein, Jeremy C, 1991. "Transactional Risk, Market Crashes, and the Role of Circuit Breakers," The Journal of Business, University of Chicago Press, vol. 64(4), pages 443-62, October.
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  17. Kandel, Eugene & Pearson, Neil D, 1995. "Differential Interpretation of Public Signals and Trade in Speculative Markets," Journal of Political Economy, University of Chicago Press, vol. 103(4), pages 831-72, August.
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Cited by:
  1. Benjamas Jirasakuldech & Robert Campbell & John Knight, 2006. "Are There Rational Speculative Bubbles in REITs?," The Journal of Real Estate Finance and Economics, Springer, vol. 32(2), pages 105-127, March.
  2. Kenneth A. Froot & Tarun Ramadorai, 2001. "The Information Content of International Portfolio Flows," NBER Working Papers 8472, National Bureau of Economic Research, Inc.
  3. Pereira, Pedro Luiz Valls, 2009. "Evaluation of contagion or interdependence in the financial crises of Asia and Latin America, considering the macroeconomic fundamentals," Textos para discussão 177, Escola de Economia de São Paulo, Getulio Vargas Foundation (Brazil).
  4. Joseph Chen & Harrison Hong & Jeremy C. Stein, 2000. "Forecasting Crashes: Trading Volume, Past Returns and Conditional Skewness in Stock Prices," NBER Working Papers 7687, National Bureau of Economic Research, Inc.
  5. Anthony S. Tay & Aamir R. Hashmi, 2004. "Global and Regional Sources of Risk in Equity Markets: Evidence from Factor Models with Time-Varying Conditional Skewness," Econometric Society 2004 Far Eastern Meetings 634, Econometric Society.
  6. Joseph Chen & Harrison Hong & Jeremy C. Stein, 2001. "Breadth of Ownership and Stock Returns," NBER Working Papers 8151, National Bureau of Economic Research, Inc.
  7. Cheolbeom Park, 2001. "Stock Returns and the Dispersion in Earnings Forecasts," Departmental Working Papers wp0117, National University of Singapore, Department of Economics.

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