When common knowledge becomes common doubt - Modeling IT-induced ambiguities about the strategic situation as reasons for flash crashes

Abstract

Flash crashes, perceived as sharp drops in market prices that rebound shortly after, have turned the public eye towards the vulnerability of IT-based stock trading. In this paper we explain flash crashes as the result of actions made by rational agents. We argue that information technology, 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. We also discuss endogenous and exogenous mechanisms that may alleviate the threat of a flash crash and present possible options for future research. © 2014 IEEE.