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Why Stock Markets CrashCritical Events in Complex Financial Systems$
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Didier Sornette

Print publication date: 2017

Print ISBN-13: 9780691175959

Published to Princeton Scholarship Online: May 2018

DOI: 10.23943/princeton/9780691175959.001.0001

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Fundamentals of Financial Markets

Fundamentals of Financial Markets

(p.26) Chapter 2 Fundamentals of Financial Markets
Why Stock Markets Crash

Didier Sornette

Princeton University Press

This chapter discusses the fundamental characteristics and properties of stock markets and the way prices vary from one instant to the next. It first introduces the standard view about price variations and returns on the stock market, using a simple toy model to illustrate why arbitrage opportunities (the possibility to get a “free lunch”) are often washed out by the intelligent investment of informed traders, giving rise to the concept of the efficient stock market. It then considers the efficient market hypothesis in relation to random walk by analyzing Louis Bachelier's thesis that the trajectories of stock market prices are identical to random walks. It also examines how information is incorporated in prices, thus destroying potential “free lunches.” Finally, it explains the trade-off between risk and expected return.

Keywords:   stock market, returns, arbitrage opportunities, efficient market, Louis Bachelier, stock market prices, random walk, free lunch, risk

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