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When Are Market Crashes Driven by Speculation?

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  • Patrick Leoni

Abstract

A natural conjecture is that speculative trade disappears when individual beliefs become correct through learning. Sandroni in [22] gives a counterexample in an economy with sunspots. We generalize Sandroni's result by showing that the conjecture holds for economies with complete markets only. We consider a standard finite-horizon General Equilibrium model with complete markets, where uncertainty is represented by fluctuations in individual endowments. Individual beliefs are formed through arbitrary learning processes, and become eventually correct. We show that along every path of events, equilibrium prices of traded assets converge to rational expectations for the sup-norm. We also give a set of sufficient conditions on beliefs and aggregate endowment leading to market crashes, as in Sandroni [22]. We show that such situations are generically continuous perturbations of rational expectations behaviors when beliefs satisfy a requirement introduced here.

Suggested Citation

  • Patrick Leoni, "undated". "When Are Market Crashes Driven by Speculation?," IEW - Working Papers 197, Institute for Empirical Research in Economics - University of Zurich.
  • Handle: RePEc:zur:iewwpx:197
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    File URL: http://www.econ.uzh.ch/static/wp_iew/iewwp197.pdf
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    References listed on IDEAS

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    1. Debreu, Gerard, 1970. "Economies with a Finite Set of Equilibria," Econometrica, Econometric Society, vol. 38(3), pages 387-392, May.
    2. Kurz, Mordecai, 1994. "On the Structure and Diversity of Rational Beliefs," Economic Theory, Springer;Society for the Advancement of Economic Theory (SAET), vol. 4(6), pages 877-900, October.
    3. 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 831-872, August.
    4. Stephen Morris, 1996. "Speculative Investor Behavior and Learning," The Quarterly Journal of Economics, Oxford University Press, vol. 111(4), pages 1111-1133.
    5. Milgrom, Paul & Stokey, Nancy, 1982. "Information, trade and common knowledge," Journal of Economic Theory, Elsevier, vol. 26(1), pages 17-27, February.
    6. Cass, David & Shell, Karl, 1983. "Do Sunspots Matter?," Journal of Political Economy, University of Chicago Press, vol. 91(2), pages 193-227, April.
    7. Harris, Milton & Raviv, Artur, 1993. "Differences of Opinion Make a Horse Race," Review of Financial Studies, Society for Financial Studies, vol. 6(3), pages 473-506.
    8. Debreu, Gerard, 1974. "Excess demand functions," Journal of Mathematical Economics, Elsevier, vol. 1(1), pages 15-21, March.
    9. Aloisio Araujo & Alvaro Sandroni, 1999. "On the Convergence to Homogeneous Expectations when Markets Are Complete," Econometrica, Econometric Society, vol. 67(3), pages 663-672, May.
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    Cited by:

    1. Bruno S. Frey & Simon Luechinger & Alois Stutzer, 2007. "Calculating Tragedy: Assessing The Costs Of Terrorism," Journal of Economic Surveys, Wiley Blackwell, vol. 21(1), pages 1-24, February.

    More about this item

    Keywords

    Asset Pricing; Speculation; Market Crashes;

    JEL classification:

    • G12 - Financial Economics - - General Financial Markets - - - Asset Pricing; Trading Volume; Bond Interest Rates

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