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Amplification and Asymmetry in Crashes and Frenzies

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Han N. Ozsoylev

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Abstract

We often observe disproportionate reactions to tangible information in large stock price movements. Moreover these movements feature an asymmetry: the number of crashes is more than that of frenzies in the S&P 500 index. This paper offers an explanation for these two characteristics of large movements in which hedging (portfolio insurance) causes amplified price reactions to news and liquidity shocks as well as an asymmetry biased towards crashes. Risk aversion of traders is shown to be essential for the asymmetry of price movements. Also, we show that differential information enhances both amplification and asymmetry delivered by hedging.

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Paper provided by Oxford Financial Research Centre in its series OFRC Working Papers Series with number 2005fe11.

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Date of creation: 2005
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Handle: RePEc:sbs:wpsefe:2005fe11

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Web page: http://www.finance.ox.ac.uk
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G11 - Financial Economics - - General Financial Markets - - - Portfolio Choice; Investment Decisions
G12 - Financial Economics - - General Financial Markets - - - Asset Pricing

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  1. Boldrin, Michele & Levine, David K., 2001. "Growth Cycles and Market Crashes," Journal of Economic Theory, Elsevier, vol. 96(1-2), pages 13-39, January. [Downloadable!] (restricted)
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  2. Gennotte, Gerard & Leland, Hayne, 1990. "Market Liquidity, Hedging, and Crashes," American Economic Review, American Economic Association, vol. 80(5), pages 999-1021, December. [Downloadable!] (restricted)
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  3. Joseph Zeira, 2000. "Informational overshooting, booms and crashes," Proceedings, Federal Reserve Bank of San Francisco, issue Apr. [Downloadable!]
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  4. Lee, I.H. & Chalkley, M., 1994. "Asymmetric Business Cycles," Discussion Paper Series In Economics And Econometrics 9411, Economics Division, School of Social Sciences, University of Southampton.
  5. Veldkamp, Laura L., 2005. "Slow boom, sudden crash," Journal of Economic Theory, Elsevier, vol. 124(2), pages 230-257, October. [Downloadable!] (restricted)
  6. Sanford J. Grossman & Joseph E. Stiglitz, 1980. "On the Impossibility of Informationally Efficient Markets," NBER Reprints 0121, National Bureau of Economic Research, Inc.
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  7. Veronesi, Pietro, 1999. "Stock Market Overreaction to Bad News in Good Times: A Rational Expectations Equilibrium Model," Review of Financial Studies, Oxford University Press for Society for Financial Studies, vol. 12(5), pages 975-1007.
  8. Demange Gabrielle & Laroque Guy, 1995. "Private Information and the Design of Securities," Journal of Economic Theory, Elsevier, vol. 65(1), pages 233-257, February. [Downloadable!] (restricted)
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  9. Admati, Anat R, 1985. "A Noisy Rational Expectations Equilibrium for Multi-asset Securities Markets," Econometrica, Econometric Society, vol. 53(3), pages 629-57, May. [Downloadable!] (restricted)
  10. Lawrence R. Glosten & Paul R. Milgrom, 1983. "Bid, Ask and Transaction Prices in a Specialist Market with Heterogeneously Informed Traders," Discussion Papers 570, Northwestern University, Center for Mathematical Studies in Economics and Management Science. [Downloadable!]
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  11. David M. Cutler & James M. Poterba & Lawrence H. Summers, 1989. "What Moves Stock Prices?," NBER Working Papers 2538, National Bureau of Economic Research, Inc. [Downloadable!] (restricted)
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  12. Grossman, Sanford J, 1988. "An Analysis of the Implications for Stock and Futures Price Volatility of Program Trading and Dynamic Hedging Strategies," Journal of Business, University of Chicago Press, vol. 61(3), pages 275-98, July. [Downloadable!] (restricted)
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  13. Hellwig, Martin F., 1980. "On the aggregation of information in competitive markets," Journal of Economic Theory, Elsevier, vol. 22(3), pages 477-498, June. [Downloadable!] (restricted)
  14. Bulow, Jeremy & Klemperer, Paul, 1994. "Rational Frenzies and Crashes," Journal of Political Economy, University of Chicago Press, vol. 102(1), pages 1-23, February. [Downloadable!] (restricted)
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