Mini-Flash Crashes, Model Risk, and Optimal Execution

48 Pages Posted: 30 May 2017  

Erhan Bayraktar

University of Michigan at Ann Arbor - Department of Mathematics

Alexander Munk

University of Michigan at Ann Arbor - Department of Mathematics

Date Written: May 27, 2017

Abstract

Oft-cited causes of mini-flash crashes include human errors, endogenous feedback loops, the nature of modern liquidity provision, fundamental value shocks, and market fragmentation. We develop a mathematical model which captures aspects of the first three explanations. Empirical features of recent mini-flash crashes are present in our framework. For example, there are periods when no such events will occur. If they do, even just before their onset, market participants may not know with certainty that a disruption will unfold. Our mini-flash crashes can materialize in both low and high trading volume environments and may be accompanied by a partial synchronization in order submission.

Instead of adopting a classically-inspired equilibrium approach, we borrow ideas from the optimal execution literature. Each of our agents begins with beliefs about how his own trades impact prices and how prices would move in his absence. They, along with other market participants, then submit orders which are executed at a common venue. Naturally, this leads us to explicitly distinguish between how prices actually evolve and our agents’ opinions. In particular, every agent’s beliefs will be expressly incorrect.

As far as we know, this setup suggests both a new paradigm for modeling heterogeneous agent systems and a novel blueprint for understanding model misspecification risks in the context of optimal execution.

Keywords: Flash Crash, Knightian Uncertainty, Model Error, Optimal Execution

Suggested Citation

Bayraktar, Erhan and Munk, Alexander, Mini-Flash Crashes, Model Risk, and Optimal Execution (May 27, 2017). Available at SSRN: https://ssrn.com/abstract=2975769 or http://dx.doi.org/10.2139/ssrn.2975769

Erhan Bayraktar (Contact Author)

University of Michigan at Ann Arbor - Department of Mathematics ( email )

2074 East Hall
530 Church Street
Ann Arbor, MI 48109-1043
United States

Alexander Munk

University of Michigan at Ann Arbor - Department of Mathematics ( email )

2074 East Hall
530 Church Street
Ann Arbor, MI 48109
United States

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