Psychological Aspects of Market Crashes

The basic insight of our results is that, when anticipating a future albeit
uncertain drop in aggregate endowments, traders take immediate financial
positions to hedge against this event. The hedging can only be achieved by
purchasing assets paying off positive dividends in this event, thus current
purchasing prices are high and in turn returns are low at the time dividends
are paid. This intuition also shows why agents must not be constrained in
borrowing, since otherwise the demand for assets would be bounded above
and prices could not be high enough to generate significant crashes. The
importance of limiting borrowing possibilities in similar situations can be
found in Hong and Stein (2003), although in this last reference short-sale
constraints prevent bearish investors from initially participating in markets
and revealing their information through prices.

Psychological factors affecting market volatility in our analysis are both
at individual and social levels. At individual level, those factors can be for
instance herding, market rumors, fear of contagion or panic (or possibly all
those issues together, see Shiller, 2000). We do not sort which one seems
most likely, but rather we argue that every psychological factor leading to an
individual anticipation contributes to both a crash occurrence and its magni-
tude. Our analysis emphasizes that anticipations of changes in fundamentals
are a key element to a crash, regardless of their formations and predictive
accuracy. At social level, it must also be true that bearish sentiments must
be shared by most traders (rumors or panic reached the whole market for
instance); that is, market exuberance leading to a significant increase in mar-
ket volatility (as in Shiller, 2000) must emerge from a behavioral correlation

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