Article2008

ADAPTIVE EXPECTATIONS AND STOCK MARKET CRASHES*

20 citations0/0 files storedInternational Economic Review

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Financial Markets and Investment Strategies Stochastic processes and financial applications Economic theories and models

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.

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References

1986Generalized autoregressive conditional heteroskedasticity 1982Autoregressive Conditional Heteroscedasticity with Estimates of the Variance of United Kingdom Inflation 1965The Behavior of Stock-Market Prices 1985Does the Stock Market Overreact?1973On the psychology of prediction.1963The Variation of Certain Speculative Prices 1972Subjective probability: A judgment of representativeness 1997The variation of certain speculative prices

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