Effect Of Heterogeneous Beliefs On Stock Price: Bubbles And Crashes

This paper conducts empirical test on the two-way effect of heterogeneous beliefs on stock price:bubbles and crashes. Chen, Hong and Stein (2002) raised a model which shows the effect and mechanism of heterogeneous beliefs on stock bubbles. The model points out that stock bubbles are always companied with large trading volume. On the other hand, Hong and Stein (2003) came up with a model to analyze the mechanism of heterogeneous beliefs on the probability of crashes, which at the same time finds a positive correlation between trading volume and the probability. What’s more, Scheinkman and Xiong (2006) showed that trading volume has a negative relationship with asset float, which indicates the speculative purpose behind the trading volume.We use data from Chinese stock market to test the theories above by Fama MacBeth regression. Firstly, we testify significant positive relationship between turnover rate and both bubbles and crashes. After that, we further proves it is the speculative factor that pushes trading volume. Also, trading volume is highly connected with heterogeneous beliefs among investors. By all the tests, we show that heterogeneous beliefs have significant effect on both stock bubbles and the probability of crashes.Since the theories we based all have an assumption of short-sales constraints, we use data before 2010 in our country to assure strict short-sales constraints in the test. To analyze the effect of this assumption, we also choose data after 2010 to do a comparison, by which we prove that the relaxing of short-sales constraints can reduce the abnormal movement of stock price caused by heterogeneous beliefs. This finding can provide political insights on the stabilization of stock markets.