Differences of Opinion, Rational Arbitrage and Market Crashes

Harrison Hong and Jeremy Stein

No 7376, NBER Working Papers from National Bureau of Economic Research, Inc

Abstract: 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.

JEL-codes: G12 G14 (search for similar items in EconPapers)
Date: 1999-10
New Economics Papers: this item is included in nep-fin
Note: AP
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Citations: View citations in EconPapers (14)

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.

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