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Anticipation of changes in fundamentals, driven by psychological factors as
discussed in this study, is shown here to be a key explanatory factor for market volatility. Here
it is intended to show that, in a general equilibrium framework, belief-driven variations
in demand are necessary conditions for crashes to occur, and that the origins of
market crashes stem from both psychological and economic factors, and not from variations
in fundamentals alone.
The basic premise is that, when anticipating a future, albeit uncertain, drop
in aggregate endowments, traders take immediate financial positions to hedge against
this contingency. Hedging can only be achieved by purchasing assets which yield
positive dividends. Thus current purchasing prices are high. In turn, the returns are low at the
time the 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, it is shown that short-sale constraints prevent bearish investors
from initially participating in markets and disclosing their information through prices. |
