Loss aversion and market crashes

Samuel Ouzan

Economic Modelling, 2020, vol. 92, issue C, 70-86

Abstract: This study proposes a rational expectation equilibrium model of stock market crashes with information asymmetry and loss averse speculators. We obtain a state-dependent linear optimal trading strategy, which makes the equilibrium price tractable. The model predicts nonlinear market depth and the result that small shocks to fundamentals (e.g., supply or informational shocks) can cause abrupt price movements. We demonstrate that short-sale constraints intensify asset price collapses relative to upward movements. The model also generates contagion between uncorrelated assets. These results are consistent with the main puzzling features observed during market crashes, namely abrupt and asymmetric price movements that are not driven by major news events but coupled with a spillover effect between unrelated markets.

Keywords: Contagion; Information asymmetry; Loss aversion; Market crashes; Short-sale constraints (search for similar items in EconPapers)
JEL-codes: D03 D82 G11 G12 G41 (search for similar items in EconPapers)
Date: 2020
References: View references in EconPapers View complete reference list from CitEc
Citations: View citations in EconPapers (3)

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Persistent link: https://EconPapers.repec.org/RePEc:eee:ecmode:v:92:y:2020:i:c:p:70-86

DOI: 10.1016/j.econmod.2020.06.015

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