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Differences of Opinion, Rational Arbitrage and Market Crashes

  • Harrison Hong
  • Jeremy C. Stein

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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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
Note: AP
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  18. Duffee, Gregory R., 1995. "Stock returns and volatility A firm-level analysis," Journal of Financial Economics, Elsevier, vol. 37(3), pages 399-420, March.
  19. Glosten, Lawrence R & Jagannathan, Ravi & Runkle, David E, 1993. " On the Relation between the Expected Value and the Volatility of the Nominal Excess Return on Stocks," Journal of Finance, American Finance Association, vol. 48(5), pages 1779-1801, December.
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