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Market crashes and informational avalanches

Market crashes and informational avalanches
Market crashes and informational avalanches
This paper analyses a security market with transaction costs and a sequential trading structure. Transaction costs may prevent many traders from revealing their private information if they trade in a sequential fashion. Due to the information aggregation failure, hidden information gets accumulated in the market which may be revealed by a small trigger, yielding a high volatility in the absence of an accompanying event. The paper first characterizes the optimal trading strategy of the agent which constitute the unique equilibrium. Further properties of the price sequence are obtained using the concepts of informational cascade and informational avalanche.
The results are applied to the explanation of market crashes. In particular, the dynamics of market crashes are illustrated as evolving through the following four phases: (1) boom; (2) euphoria; (3) trigger; and (4) panic; where the euphoria corresponds to the informational cascade and the panic corresponds to the informational avalanche.
0034-6527
741-759
Lee, I.H.
dc1302c9-2a3e-4639-a587-c8d8ffbca42e
Lee, I.H.
dc1302c9-2a3e-4639-a587-c8d8ffbca42e

Lee, I.H. (1998) Market crashes and informational avalanches. Review of Economic Studies, 65 (4), 741-759. (doi:10.1111/1467-937X.00066).

Record type: Article

Abstract

This paper analyses a security market with transaction costs and a sequential trading structure. Transaction costs may prevent many traders from revealing their private information if they trade in a sequential fashion. Due to the information aggregation failure, hidden information gets accumulated in the market which may be revealed by a small trigger, yielding a high volatility in the absence of an accompanying event. The paper first characterizes the optimal trading strategy of the agent which constitute the unique equilibrium. Further properties of the price sequence are obtained using the concepts of informational cascade and informational avalanche.
The results are applied to the explanation of market crashes. In particular, the dynamics of market crashes are illustrated as evolving through the following four phases: (1) boom; (2) euphoria; (3) trigger; and (4) panic; where the euphoria corresponds to the informational cascade and the panic corresponds to the informational avalanche.

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More information

Published date: 1998
Organisations: Economics

Identifiers

Local EPrints ID: 32985
URI: http://eprints.soton.ac.uk/id/eprint/32985
ISSN: 0034-6527
PURE UUID: 65e32179-ae75-4fa6-b88b-a69a673b92e9

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Date deposited: 21 Jun 2007
Last modified: 15 Mar 2024 07:40

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Author: I.H. Lee

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