Cursed hedge funds and market crashes

We build a cursed expectations equilibrium model to clarify the market crashes of micro-cap stocks in the A-share market. In this model, cursed hedge funds, neglecting the informational content of micro-cap stocks’ prices, engage in speculative trading of these stocks while hedging with stock index futures. The cursed feature gives rises to multiple equilibria through an uncertainty-amplified channel: Cursed hedge funds can only extract imprecise public signals from the prices of stock index futures, thereby amplifying their uncertainty in demand for both micro-cap stocks and stock index futures, resulting in financial markets exhibiting multiple equilibria. Within the equilibrium related to market crashes, the micro-cap stock market features low price informativeness, low liquidity, and a high cost of capital, whereas the stock index futures market displays low price informativeness, high liquidity, and an increased futures price bias. We propose practical policy measures to mitigate and detect market crash risks, including imposing investment limits on hedge funds trading micro-cap stocks and implementing a real-time monitoring system to track price discrepancies between micro-cap stocks and index futures.