ADAPTIVE EXPECTATIONS AND STOCK MARKET CRASHES* |
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| Authors: | David M. Frankel |
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| Affiliation: | 1. Iowa State University, U.S.A.;2. I thank seminar participants at UC‐Berkeley (Haas), the University of Kansas, NHH, Tel Aviv University, and participants in the Behavioral Asset Pricing session of the 2005 Annual Meeting of the American Finance Association. I also thank Gady Barlevy, Zvika Eckstein, Amir Kirsh, Ady Pauzner, Assaf Razin, Simon Benninga, Frank Schorfheide (the editor), and a referee for helpful comments. Please address correspondence to: David M. Frankel, Department of Economics, Iowa State University, Heady Hall, Ames, IA 50011, U.S.A. E‐mail: . |
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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. |
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