Linking Historical Market Crashes: A Market Microstructure Model and Statistical Evidence

Studies of stock market crashes are as sparse as the occurrence ofcrashes. The mainstream theoretical models on stock market crashes are rooted in rationalexpectations equilibrium models and classicalmarket microstructure models. Compared to theoretical works, there areeven fewer works done on the empirical side. This is because most ofthe theoretical models do not provide straightforward tests againstempirical data. Secondly, the relatively smallsample size (rare occurrence) of stock market crashes is always an obstacle forempirical testing. In this dissertation, we build a strategic trading model to link two major US stock marketcrashes: the 1987 crash and the 2010 Flash Crash. We then providecross-sectional empirical evidence to verify our model hypothesis and evaluate price impact dueto the information asymmetry effect and the limited risk-bearing capacity effect. We use statistical learningmethods to compare our model based predictors with other predictorsfor the maximum cross-sectional price drawdown of SP500 stocks during the 2010 Flash Crash andcheck the robustness of ourfindings