Loss Aversion and Market Crashes
40 Pages Posted: 23 Apr 2019
Date Written: January 8, 2019
This study proposes a rational expectation equilibrium model of crashes in an economy with information asymmetry and loss averse speculators. We obtain a state-dependent linear optimal trading strategy, which makes the equilibrium price tractable for the first time in such an economy. The model predicts nonlinear market depth and the fact that small shocks to fundamentals (e.g., supply or informational shocks) can cause abrupt price movements. We demonstrate that short-sale constraints intensify asset price collapses relative to upward movements. The model also generates contagion between uncorrelated assets. These results reflect the main puzzling features observed during market crashes, namely abrupt and asymmetric price movements, not driven by major news events, coupled with a spillover effect between unrelated markets.
Keywords: contagion; information asymmetry; loss aversion; market crashes; short-sale constraints
JEL Classification: G12; G41; D82
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