Psychological determinants of occurrence and magnitude of market crashes

We simulate the Dynamic Stochastic General Equilibrium model of Mehra-Prescott [14] to establish the link between the anticipation of endowment drops (for instance a recession) and sudden market crashes. Contrary to the commonly accepted view that those crashes are solely driven by large drops in endowments at the time they occur, the simulation shows that: 1-a large and subjective anticipation of an endowment drop amplifies the magnitude of the crash next period without permanent effects, and 2-there always exists an upper-bound on the maximal anticipation of the drop so that the crash magnitude next period remains constant regardless of the drop level. Those findings are independent of the risk aversion of agents, and of the formation process of the anticipation.

Research highlights►We simulate a DGSE model to link anticipation of endowment drops and crashes. ►We find that subjective anticipations of drops amplify crash magnitudes. ►A bound on the anticipation leaving the crash constant regardless of the drop. ►This is independent of risk aversion and of the anticipation formation.