NATIONAL BUREAU OF ECONOMIC RESEARCH
NATIONAL BUREAU OF ECONOMIC RESEARCH

Differences of Opinion, Rational Arbitrage and Market Crashes

Harrison Hong, Jeremy C. Stein

NBER Working Paper No. 7376
Issued in October 1999
NBER Program(s):   AP

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.

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Document Object Identifier (DOI): 10.3386/w7376

Published: Hong, Harrison and Jeremy C. Stein. "Differences Of Opinion, Short-Sales Constraints, And Market Crashes," Review of Financial Studies, 2003, v16(2,Summer), 487-525.

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