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

Studies of stock market crashes are as sparse as the occurrence of crashes. The mainstream theoretical models on stock market crashes are rooted in rational expectations equilibrium models and classical market microstructure models. Compared to theoretical works, there are even fewer works done on the empirical side. This is because most of the theoretical models do not provide straightforward tests against empirical data. Secondly, the relatively small sample size (rare occurrence) of stock market crashes is always an obstacle for empirical testing.;In this dissertation, we build a strategic trading model to link two major US stock market crashes: the 1987 crash and the 2010 Flash Crash. We then provide cross-sectional empirical evidence to verify our model hypothesis and evaluate price impact due to the information asymmetry effect and the limited risk-bearing capacity effect. We use statistical learning methods to compare our model based predictors with other predictors for the maximum cross-sectional price drawdown of SP500 stocks during the 2010 Flash Crash and check the robustness of our findings.