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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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Modeling Financial Bubbles and Market Crashes

Modeling Financial Bubbles and Market Crashes

(p.134) Chapter 5 Modeling Financial Bubbles and Market Crashes
Why Stock Markets Crash

Didier Sornette

Princeton University Press

This chapter considers two versions of a rational model of speculative bubbles and stock market crashes. According to the first version, stock market prices are driven by the crash hazard that may increase sometimes due to the collective behavior of “noise traders.” The second version assumes the opposite: the crash hazard is driven by prices that may soar sometimes, again due to investors' speculative or imitative behavior. The chapter first provides an overview of what a model is before discussing the basic principles of model construction in finance. It then describes the basic ingredients of the two models of speculative bubbles and market crashes, along with the main properties of the risk-driven model. It also examines how imitation and herding drive the crash hazard rate and concludes with an analysis of the price-driven model, how imitation and herding drive the market price, and how the price return drives the crash hazard rate.

Keywords:   speculative bubble, stock market crash, stock market prices, crash hazard, risk-driven model, imitation, herding, hazard rate, price-driven model

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