Adaptive Expectations and Stock Market Crashes

David Frankel

Staff General Research Papers Archive from Iowa State University, Department of Economics

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.

JEL-codes: D03 D84 G01 (search for similar items in EconPapers)
Date: 2008-05-01
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Citations: View citations in EconPapers (3)

Published in International Economic Review, May 2008, vol. 49 no. 2, pp. 595-619

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http://www2.econ.iastate.edu/faculty/frankel/crashPreprint.pdf (application/pdf)

Related works:
Journal Article: ADAPTIVE EXPECTATIONS AND STOCK MARKET CRASHES (2008)
Journal Article: ADAPTIVE EXPECTATIONS AND STOCK MARKET CRASHES (2008)
Working Paper: Adaptive Expectations and Stock Market Crashes (2007)
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Persistent link: https://EconPapers.repec.org/RePEc:isu:genres:31688

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