Loss Aversion and Market Crashes

47 Pages Posted: 23 Apr 2019 Last revised: 23 Jun 2021

Date Written: January 8, 2019


This study proposes a rational expectation equilibrium model of stock market crashes with information asymmetry and loss averse speculators. We obtain a state-dependent linear optimal trading strategy, which makes the equilibrium price tractable. The model predicts nonlinear market depth and the result 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 are consistent with the main puzzling features observed during market crashes, namely abrupt and asymmetric price movements that are not driven by major news events but coupled with a spillover effect between unrelated markets.

Keywords: contagion; information asymmetry; loss aversion; market crashes; short-sale constraints

JEL Classification: D03; D82; G11; G12; G41

Suggested Citation

Ouzan, Samuel, Loss Aversion and Market Crashes (January 8, 2019). Available at SSRN: https://ssrn.com/abstract=3348318 or http://dx.doi.org/10.2139/ssrn.3348318

Samuel Ouzan (Contact Author)

Neoma Business School ( email )

1 Rue du Maréchal Juin
Mont Saint Aignan Cedex, 76825

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