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Possible Early Warning Sign for Market Crashes

Wing-Yee Man (wm235)

Blog Post #1

October 1, 2011

http://www.wired.com/wiredscience/2011/03/market-panic-signs/#more-54374

Possible Early Warning Sign for Market Crashes

This article is about warning signs for market crashes. Researchers who analyze the behavior of stock markets have found that one sign is the measure of co-movement, or the likelihood of stocks to move in the same direction. When a market is health, there is little co-movement. However, months and even years before a crash, the idea of co-movement grows. Stock market prices are always either rise, stay the same, or go down in unison and in the same direction. People always copy each other, and one small movement can create a chain reaction and send everyone in the same direction. Under the phase-transition model, shortly before a crash, co-movement is absolute. People are copying each other instead of making their own decisions. When the market is doing well, people make independent decisions. People should sense that there will be a crash when collective behaviors start building up. The financial crisis today has sown that we need to come up with better and newer theoretical approaches that can help predict market behavior. Over the years, economic systems have become much more complex. We are only beginning to understand the rules.

This article is extremely relevant to game theory. People react to what they think others will decide. A person’s success is based on the decisions of others. Game theory is used to study human behaviors and to explain economic behaviors, including market trends. It is usually expressed in the form of a matrix. This matrix shows the plays, strategies, and the payoff that accompanies each decision. There are usually best responses and equilibrium responses that go with each matrix. This article relates to game theory because people always try to act in their best interest. If they sense that something bad is going to happen, they are most likely going to copy the decisions of people around them and sell their stock, thus validating the co-movement theory. In the end, people always want to maximize their payoffs.

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