Abstract
We often observe disproportionate reactions to tangible information in large stock price movements. Moreover these movements feature an asymmetry: the number of crashes is more than that of frenzies in the S&P 500 index. This paper offers an explanation for these two characteristics of large movements in which hedging (portfolio insurance) causes amplified price reactions to news and liquidity shocks as well as an asymmetry biased towards crashes. Risk aversion of traders is shown to be essential for the asymmetry of price movements. Also, we show that differential information can enhance both amplification and asymmetry delivered by hedging.
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This paper is based on part of my Ph.D. thesis submitted to the University of Minnesota. I am grateful to Andy McLennan and Jan Werner for their valuable advice and unwavering support. Also, I would like thank Mehmet Barlo, Michele Boldrin, Partha Chatterjee, Mehmet Ozhabes, Dimitrios Tsomocos and seminar participants at the University of Minnesota, the MEA and the MFA Meetings in St Louis for helpful comments. Comments on a previous draft by an anonymous referee greatly improved the presentation of this paper. Financial support from William W. Stout Fellowship is gratefully acknowledged.
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Ozsoylev, H.N. Amplification and asymmetry in crashes and frenzies. Annals of Finance 4, 157–181 (2008). https://doi.org/10.1007/s10436-007-0077-z
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DOI: https://doi.org/10.1007/s10436-007-0077-z