Why Markets Crash Without Fundamental News - Essay Example

Why Markets Can Crash Without Fundamental News By Why Markets Can Crash Without Fundamental News Introduction Market indices can have the tendency to shift downwards considerably and without being driven by any fundamental public news regarding the market. Therefore, explaining market crashes is one of the key predicaments in economics. Even though a number of models provide distorted returns, they reveal some massive fundamental shocks in initiating crashes. As such, some models evaluate how market crashes take place when minor shifts in asymmetric variations take place with slight or no fundamental news (Abreu & Brunnermeier, 2003, p. 173). There are also other models and theories which define how markets crashes when there arises asymmetric price soars from available fundamental news. Thus, the aim of this paper is to explain why markets can crash without fundamental news using models from available literature. Discussion According to Frankel markets do crash without fundamental news because of the interaction of coherent investors with naive investors (2008, p. 595). In particular, the naive traders tend to deem that prices will observe a random-walk but with in-succession correlated volatility. Such traders envisage that future volatility will adjust as weighted averages of up-to-the-minute squared price variations. Therefore, their hope is that future volatility will be generated adaptively. That’s why when the market collapses, the naive traders will sell their stocks in reaction to perceptible or perceived boost in volatility. On the other hand, given that rational traders tend to be risk averse, any lowering of stock prices will be deemed as necessary in order to crumble the market. Such traders envisage future volatility through the application of other rational investor’s knowledge and strategies. Hence, to Frankel market crashes without fundamental news are self-fulfilling prediction and frenzies cannot take place in such a representation (2008, p. 610). Rational investors examine any common signal which acts as a form of coordinating mechanism, and for any given value of such signals, the traders tend to reduce the price they bid, which in the end results in plummeting of prices (Barlevy & Veronesi, 2003, p. 235). Such quick price changes increases the naive investor’s judgment of risk, and given that naïve investors are unenthusiastic to risks, they then shy off from the market. This then results in a crash that reflects a self-fulfilling prediction for the rational investors. Furthermore, this premise avoids the frenzy associated with the reaction to fundamentals news, since it reduces the risk bearing capabilities of the market. According to Frankel the naive investor assumes that any greater price variation tends to be trailed by more outsized changes (2008, p.611). Also, insider trading in most ways makes the market to experience positive or negative market psychology. Hence, the resultant fluctuations in real prices above the obscure changes but within fundamental variables are as a result of fads or otherwise waves (Lakonishok & Lee, 2001, p. 80). Notably, the insider trader unlike the uninformed trader is risk averse and focuses on noisy signal regarding the fundamentals. Therefore, when insider traders do not do business but instead floor restriction binding, the uninformed traders will deduce that the insider trader acquired bad news and since they cannot deduce how truly the news is bad they stop buying or selling. As a result, there occurs a lesser but anticipated payoff including a higher uncertainty resulting in market price crashes (Lakonishok & Lee, 2001, p. 79). However, when insider investors put up for sale the stocks, the uninformed traders discern the sales and a partial downhill adjustment of price takes place, which is relative to insider trader sales. Moreover, in scenarios whereby stock traders previously overvalued dividends growth-rate, and then they later underestimate the defined rates, negative skews are formed from short-sale restrictions. Thus, when the negative skews are substituted with margin restraints on leveraged purchasing, market crashes do occur and in extreme cases frenzies can take place due to risk aversion (Frankel, 2008, p. 607). This is attributed to nonstandard suppositions regarding signal distribution, since a price turn down can signal off-putting indication to unapprised investors. As a result, the price reduces further, thus signaling the likelihood of even worse performance. Under volatility feedback, superior market volatility results in elevated risk premium which then leads to lower prices and such an effect can generate negative skews as price declines become massive generally, compared to price advances (Frankel, 2008, p. 601). Hence, when risk-averse investors deem that prices mirror in-sequence but correlated volatility, then their existence within the market can result in non-fundamental news market crashes with no frenzies. The supposition of downbeat exponential utility including on average distributed dividends reveals that market crashes tend to occur in a typical configuration whereby dividends are considered as serially correlated, with no fundamental news which is significant to the stock-price. Hence, when the investors make trades naive agents concurrently offer demand functions or the amount of shares they desire to purchase at every price, while the rational investor presents a sole limit-order, and because there is a range of market agents, they will then proceed as price-takers (Frankel, 2008, p. 595). Therefore, by undertaking limit-orders, rational investors collectively establish if a market crash will take place by selecting a certain position within their demand-curves. Consequently, this results in decentralized market crashes as many diverse investors abruptly decide to pay a lower price because they forecast that the stock-price will be lower. Naive traders tend to make mistakes that lead them to sell their portfolios. Firstly, they will not consider the fact that in terms of risk aversion supposition, anticipated returns are probably higher as volatility is elevated. They instead continue to assume that after the market crashes, prices will observe a random walk even as they misjudge post-crash volatility (Frankel, 2008, p.611). Shiller observed that stock price or derivatives markets increases can be pushed by unreasonable and illogical euphoria between individual investors, who are bombarded with items from an emphatic media and which are bent on maximizing their ratings (1987, p. 35). The emphatic media instead of providing fundamental news, they release pseudo news with an intention of fulfilling such investors command, and this creates a dangerous disconnect involving the short-term and intermediate term responses of stock values to news. Frankel observes that an upswing normally begins with occasions provided by a new market, or technology, and as it advances through the generated euphoria of ever increasing prices of assets, a bubble is formed due to extension of credit (2008, p. 596). Thus, a large group of naive investors seeks to get returns without real comprehension of processes and dynamics involved. in due course, the market discontinue rising and naive investors who borrowed a great deal become overstretched, thus creating a distress that fashions an unexpected failures, pursued by revulsion. In the end, self-feeding panics results in the crashing of the market as investors scramble to offload at massive losses. There are some levels of irrationality within the market, specifically, when traders demand for stocks is being pushed by overconfidence in future outlook under a restricted arbitrage environment. As such, market crashes take place when floor constriction is binding (Frankel, 2008, p. 597). Regardless of the massive progression in information technology and emancipation of free media, it is still hard to link key stock-price movements with fundamental news that are ample to cause market crashes. This is because the brunt of fundamental news relies not just on the significance of the particular news story, but on the degree in which the news was projected. That’s why a huge number of investments create a bigger measure of signals. There is a tendency for traders to classify events or actions as typical of a reputed class of traders, and when they try to make probability estimates, they tend to ignore fundamental news evidence regarding underlying probabilities. As an example, during the US Federal government takeover of mortgage giant Fannie Mae in 2008 had every signs of fundamental news. However the market reaction during that particular day did not create a significant crash since it was largely anticipated (Frankel, 2008, p. 597). Abreu & Brunnermeier observed that extensive selling from financially distraught mutual funds results in considerably depressed stocks prices within their portfolio (2003, p. 175). Such price outcomes can subsist over a pair of quarters, before reversing under several more quarters. Besides, such effect takes place even though a lot of the stocks sold may be under a single portfolio and not undergoing outflows problems, or are being in custody by mutual funds with no outflows issues. This contradicts the apparent media perspective that viewers need explanations regarding significant market movements and not enlightenment that are linked to fundamental economics. Hence, Barlevy & Veronesi (2003, p. 250), observed that markets like convertible bonds or acquisitions whereby hedge-funds aggressively chase pricing anomalies and massive redemptions, the market prices tend to deviate considerably from the basics. In particular, the investors become slower in streaming back in the market and when such price deviations persevere for a long time market begins to diminish before it crashes. Therefore, such perseverance in massive price deviations resulting in liquidity outcomes reveals that considerable frictions prevent immediate capital flow and market participation rather than fundamental news (Frankel, 2008, p. 595). Conclusion The key explanation as to why markets crashes without fundamental news is that some naïve investors instead of considering strategic activities of other traders and agents, they assume that prices will observe random-walk projection with in-sequence correlated volatility. In that case, given that rational investors are largely risk averse they only require lower prices to abscond the market, which then results in a crash, in a rather self-fulfilling prediction rather than a frenzy. In any dynamic and internationally driven strategic complementarities, markets can be destabilized thus leading to a crash when speculators trades take place sequentially and in a random order. This is because capital and margins necessities become more severe when liquidity is stretched thus creating a long-run overreaction. List of References Abreu, D. & Brunnermeier, M., 2003. Bubbles and Crashes. Econometrica, Volume 71, p. 173–204. Barlevy, G. & Veronesi, P., 2003. Rational Panics and Stock Market Crashes. Journal of Economic Theory , Volume 110, p. 234–263. Frankel, D. M., 2008. Adaptive Expectations And Stock Market Crashes. International Economic Review, 49(2), pp. 595-619. Lakonishok, J. & Lee, I., 2001. Are insider trades informative?. Review of Financial Studies, Volume 14, p. 79 – 11. Shiller, R. J., 1981. Do Stock Prices Move Too Much to be Justified by Subsequent Changes in Dividends?. American Economic Review, 235(4784), pp. 33-37. Read More