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Flash crash and policy uncertainty

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  • Tsai, I-Chun

Abstract

This paper constructs a generalized theoretical model to examine potentially high price variation and insufficient liquidity as the requirements for an enormous crash in a short period. In a market with insufficient liquidity, rapid changes in information induce selling pressure, therefore, this paper defines the prerequisite of a flash crash (large-scale decline in a short period of time) as when a market has insufficient liquidity and high price variability. Policy uncertainty provides an environment conducive to the occurrence of flash crashes. The paper examines the effect of economic policy uncertainty on the daily returns of the U.K. stock and foreign exchange markets. The results reveal that policy uncertainty is highly correlated with the risk of short-term, large-scale decline, which validates the theoretical inference of this paper. Although the timing at which extreme risks emerge is difficult to predict, this paper includes policy uncertainty as a factor to explain market conditions that can lead to flash crashes and remind traders to consider this factor when predicting the risk and value at risk of a market.

Suggested Citation

  • Tsai, I-Chun, 2018. "Flash crash and policy uncertainty," Journal of International Financial Markets, Institutions and Money, Elsevier, vol. 57(C), pages 248-260.
  • Handle: RePEc:eee:intfin:v:57:y:2018:i:c:p:248-260
    DOI: 10.1016/j.intfin.2018.09.002
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    References listed on IDEAS

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