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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.

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  • 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:wly:iecrev:v:49:y:2008:i:2:p:595-619
    DOI: 10.1111/j.1468-2354.2008.00491.x
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