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Avalanches Earthquakes and Stock Market Crashes
Nov 1, 1996
One of the most important and successful concepts in finance is the stochastic process. Although stochastic processes originated from a study of Brownian motion in physics, they have since been applied to many areas in finance including options valuation, equity risk modeling, and fixed income risk modeling. Recently, another concept in physics, the theory of self-organized criticality, has generated much excitement. This theory, which has already been applied to such diverse areas as earthquakes, avalanches, the economy, and evolution, has also been proposed as a theory for understanding stock market crashes. While traditionally, these phenomena have been viewed as unrelated events, the theory of self-organized criticality had been proposed as the unifying theory that explains the nature of these seemingly unrelated phenomena. In this article, we will discuss the theory of self-organized criticality, and search for evidence of self-organized criticality in the stock market. We will also discuss the implications for money managers in the stock market.