If there is anything in markets that can top the emotional intensity of bubbles, it is crashes. For those who are caught on the wrong side of them, crashes are sweat-inducing, gut-wrenching events that can shake even the most hardened of market veterans. This chapter applies the previous work on bubbles to crashes and then attempts to relate all of this generally and simply to chaos theory (i.e., nonlinear dynamics) and to the velocity concepts introduced in earlier chapters.

Crashes and panics

Crashes

The New Palgrave (Newman et al., 1992) entry says a “crash” is “[W]hen a precipitous decline in value occurs for securities or assets that represent a large proportion of wealth.” Crashes are thus relatively quick and deep plunges of asset prices (not necessarily involving banking deposits): They are financial asset-pricing earthquakes that vaporize in the space of hours or days what required many months and often many years to build. A crash is thus always representative of a high-volatility condition.

Still, there are nuances. A popular and common definition of a crash is a 20% or so decline in a few days or at most over only a couple of months. The definition used by Ursua and Barro (2009) – cumulative real returns of minus 25% or worse – is similar. Such definitions, however, are not particularly useful unless they also specify the amount of time over which the decline occurs.