Abstract
Flash crashes, perceived as sharp drops in market prices that rebound shortly after, have turned the public eye toward the vulnerability of information technology-based stock trading. In this paper, we explain flash crashes as the result of actions made by rational agents. We argue that the advancement of information technology (IT), which has long been associated with competitive advantages, may cause ambiguities with respect to the game form that give rise to a hypergame. We employ hypergame theory to demonstrate that a market crash constitutes an equilibrium state if players misperceive the true game. Once the ambiguity is resolved, prices readjust to the appropriate level, creating the characteristic flash-crash effect. By analyzing the interaction with herd behavior, we find that flash crashes may be an unavoidable systemic problem of modern financial markets.
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Tobias Brandt
Tobias Brandt is a Ph.D. candidate in the Department of Economics and Behavioral Sciences at the University of Freiburg, Germany. He is also a former research affiliate at Lawrence Berkeley National Laboratory in Berkeley, California. He received his education in Freiburg and at the Università di Bologna, Italy, and holds a degree in economics from the former. His research focuses on energy informatics, data analytics, and economic modeling. His papers have appeared or are forthcoming in Business and Information Systems Engineering as well as in the proceedings of the International Conference on Information Systems, European Conference on Information Systems, and Hawaii International Conference on Systems Sciences.
Dirk Neumann
Dirk Neumann is chair of information systems in the Department of Economics and Behavioral Sciences at the University of Freiburg, Germany. He holds degrees in economics from the University of Giessen, Germany, and the University of Wisconsin–Milwaukee, as well as a Ph.D. in economic and business sciences from the Karlsruhe Institute of Technology, Germany. His research interests include novel methods for social media and spatial data analysis, transdisciplinary issues concerning information systems (IS) and sustainability, as well as IS and finance. His research papers have been published in European Journal of Operational Research, Decision Support Systems, ACM Transactions on Internet Technology, Group Decision and Negotiation, and Business and Information Systems Engineering.