Adaptive Expectations and Stock Market Crashes

25 Pages Posted: 8 May 2008

See all articles by David M. Frankel

David M. Frankel

Iowa State University - Department of Economics

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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.

Suggested Citation

Frankel, David M., Adaptive Expectations and Stock Market Crashes. International Economic Review, Vol. 49, No. 2, pp. 595-619, May 2008. Available at SSRN: https://ssrn.com/abstract=1130541 or http://dx.doi.org/10.1111/j.1468-2354.2008.00491.x

David M. Frankel (Contact Author)

Iowa State University - Department of Economics ( email )

260 Heady Hall
Ames, IA 50011
United States

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