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Equilibrium theory of stock market crashes

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  • Isaenko, Sergey

Abstract

We consider an equilibrium in illiquid stock market in which liquidity suppliers trade with investors and face significant trading costs. A similar situation was observed during the recent financial crisis. We find that the expected risk premium on the stock and its Sharpe ratio are positive and very large, while the expected stock return volatility is a few times bigger than in the liquid market. Investors sell stock shares due to their excessive leverage, whereas market makers try to compensate their trading costs with the profits expected from buying the stock shares with very high Sharpe ratio. Moreover, the short-term stock returns exhibit either a strong overreaction or a momentum effect depending on the state of the economy.

Suggested Citation

  • Isaenko, Sergey, 2015. "Equilibrium theory of stock market crashes," Journal of Economic Dynamics and Control, Elsevier, vol. 60(C), pages 73-94.
    • Handle: RePEc:eee:dyncon:v:60:y:2015:i:c:p:73-94
    DOI: 10.1016/j.jedc.2015.08.004
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    Cited by:

    1. Isaenko, Sergey, 2023. "Trading strategies and the frequency of time-series," The Quarterly Review of Economics and Finance, Elsevier, vol. 90(C), pages 267-283.
    2. Isaenko, Sergey, 2023. "Transaction costs, frequent trading, and stock prices," Journal of Financial Markets, Elsevier, vol. 64(C).

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    More about this item

    Keywords

    General equilibrium; Financial crisis; Liquidity; Transaction costs;
    All these keywords.

    JEL classification:

    • G11 - Financial Economics - - General Financial Markets - - - Portfolio Choice; Investment Decisions
    • G12 - Financial Economics - - General Financial Markets - - - Asset Pricing; Trading Volume; Bond Interest Rates

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