Differences of Opinion, Rational Arbitrage and Market Crashes

50 Pages Posted: 14 Jul 2000 Last revised: 14 Oct 2010

See all articles by Harrison G. Hong

Harrison G. Hong

Columbia University, Graduate School of Arts and Sciences, Department of Economics; National Bureau of Economic Research (NBER)

Jeremy C. Stein

Harvard University - Department of Economics; National Bureau of Economic Research (NBER)

Multiple version iconThere are 2 versions of this paper

Date Written: October 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 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.

Suggested Citation

Hong, Harrison G. and Stein, Jeremy C., Differences of Opinion, Rational Arbitrage and Market Crashes (October 1999). NBER Working Paper No. w7376. Available at SSRN: https://ssrn.com/abstract=227579

Harrison G. Hong (Contact Author)

Columbia University, Graduate School of Arts and Sciences, Department of Economics ( email )

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Jeremy C. Stein

Harvard University - Department of Economics ( email )

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HOME PAGE: http://post.economics.harvard.edu/faculty/stein/stein.html

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