Equilibrium theory of stock market crashes

Sergei Isaenko ()

Journal of Economic Dynamics and Control, 2015, vol. 60, issue C, 73-94

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; Transaction costs (search for similar items in EconPapers)
JEL-codes: G11 G12 (search for similar items in EconPapers)
Date: 2015
References: View references in EconPapers View complete reference list from CitEc
Citations: View citations in EconPapers (2)

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Persistent link: https://EconPapers.repec.org/RePEc:eee:dyncon:v:60:y:2015:i:c:p:73-94

DOI: 10.1016/j.jedc.2015.08.004

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