Differences of Opinion, Rational Arbitrage and Market Crashes
45 Pages Posted: 12 Oct 1999
There are 2 versions of this paper
Differences of Opinion, Rational Arbitrage and Market Crashes
Differences of Opinion, Rational Arbitrage and Market Crashes
Date Written: September 13, 1999
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 the 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 Classification: G12
Suggested Citation: Suggested Citation
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