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Adaptive Expectations And Stock Market Crashes

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  • David M. Frankel

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. Copyright ©2008 by the Economics Department Of The University Of Pennsylvania And Osaka University Institute Of Social And Economic Research Association.

Suggested Citation

  • David M. Frankel, 2008. "Adaptive Expectations And Stock Market Crashes," International Economic Review, Department of Economics, University of Pennsylvania and Osaka University Institute of Social and Economic Research Association, vol. 49(2), pages 595-619, May.
  • Handle: RePEc:ier:iecrev:v:49:y:2008:i:2:p:595-619
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    File URL: http://www.blackwell-synergy.com/doi/abs/10.1111/j.1468-2354.2008.00491.x
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    Cited by:

    1. Vogel, Harold L. & Werner, Richard A., 2015. "An analytical review of volatility metrics for bubbles and crashes," International Review of Financial Analysis, Elsevier, vol. 38(C), pages 15-28.
    2. Nikolaos Antonakakis & Johann Scharler, 2009. "Volatility, Information and Stock Market Crashes," Economics working papers 2009-18, Department of Economics, Johannes Kepler University Linz, Austria.

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