Equilibrium Theory of Stock Market Crashes

41 Pages Posted: 2 Jul 2010 Last revised: 9 Aug 2017

See all articles by Sergey Isaenko

Sergey Isaenko

Concordia University, Quebec - Department of Finance

Date Written: 2008

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.

Keywords: General Equilibrium, Financial Crisis, Liquidity, Asset Pricing

JEL Classification: G11, G12

Suggested Citation

Isaenko, Sergey, Equilibrium Theory of Stock Market Crashes (2008). Journal of Economic Dynamics and Control, 2015, Volume 60, 73-94, Available at SSRN: https://ssrn.com/abstract=991915 or http://dx.doi.org/10.2139/ssrn.991915

Sergey Isaenko (Contact Author)

Concordia University, Quebec - Department of Finance ( email )

John Molson School of Business
Concordia University. 1455 de Maisonneuve Blvd.W.
Montreal, Quebec, H3G 1M8
Canada
1-514-848-2424 ext.2797 (Phone)
1-514-848-4500 (Fax)

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