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Probability of Price Crashes, Rational Speculative Bubbles, and the Cross-Section of Stock Returns

  • Jeewon Jang College of Business, Chosun University
  • Jankoo Kang College of Business, Korea Advanced Institute of Science and Technology (KAIST)
A recent paper by Conrad, Kapadia, and Xing (2014) shows that stocks with high probability for extreme positive payoffs (jackpots) earn low returns subsequently. We find that stocks with high probability for extreme negative returns (crashes) earn abnormally low average returns, and that the cross-sectional return predictability of crash probability subsumes completely the jackpot effect. The most distinctive features of the crash effect we find are that the underperformance of stocks with high crash probability is clear regardless of the stocks¡¯ institutional ownership, and it is not associated with variations in investor sentiment. We also find that institutional demand for stocks with high crash probability increases until their prices arrive at the peak of overvaluation. Our evidence contradicts the presumption that sophisticated investors are always willing to trade against mispricing, and suggests that the crash effect we find may arise partially from rational speculative bubbles, not entirely from sentiment-driven overpricing.

  • Jeewon Jang
  • Jankoo Kang
A recent paper by Conrad, Kapadia, and Xing (2014) shows that stocks with high probability for extreme positive payoffs (jackpots) earn low returns subsequently. We find that stocks with high probability for extreme negative returns (crashes) earn abnormally low average returns, and that the cross-sectional return predictability of crash probability subsumes completely the jackpot effect. The most distinctive features of the crash effect we find are that the underperformance of stocks with high crash probability is clear regardless of the stocks¡¯ institutional ownership, and it is not associated with variations in investor sentiment. We also find that institutional demand for stocks with high crash probability increases until their prices arrive at the peak of overvaluation. Our evidence contradicts the presumption that sophisticated investors are always willing to trade against mispricing, and suggests that the crash effect we find may arise partially from rational speculative bubbles, not entirely from sentiment-driven overpricing.
Price crashes,Cross-section of stock returns,Anomalies,Institutional investors,Rational speculative bubbles