Fear of Crashes and Over-Reaction to Bad Shocks

Our purpose is to show how large difference of beliefs induced by fear of crashesis amenable to large and persistent price responses to contemporaneous shocks. Weconstruct a pure exchange economy populated by two agents who estimate strictlydifferent models regarding the fundamental. In particular, one agent believes thatcrashes could occur whereas the second agent has smoother beliefs. We showthat this setting is prone to generate disagreement whose persistence varies overa bearish phase. When economic conditions start to deteriorate, disagreementamong agents significantly increases in a persistent fashion. Yet, after a sustainedstreak of bad news, disagreement gradually loses of its persistence. Contrary tothe common wisdom that heterogeneous beliefs lead to large bets, we show thatthis pattern in disagreement ultimately causes the trading volume to dry up. Asa result, price sensitivity to current shocks along with persistence are shown tobe dramatically increased when compared with a model absent of heterogeneousbeliefs but with perceived crash risk. Using Google search data, we find empiricalsupport for the main implication of the model.[...]