Explaining Market Crashes

The body of academic theories for market crashes explores a number of possible explanations. Why do markets crash? There may be some event that sets everything in motion, but why and when does a decline turn from an ordinary slide to a crash? Didier Sornette wrote a book and did a TED talk on the subject. Scholars as illustrious as Fischer Black and Myron Scholes weighed in on the subject. There are four main theories addressing this phenomenon:

1. Leverage effects: Drop in prices increases leverage both operating and financial thus exacerbating volatility when businesses and investors have to raise capital to cover leverage or by reducing leverage
2. Volatility feedback: When bad news arrives, the risk premia magnifies the direct effect of the news
3. Stochastic bubbles: Crash occurs when a buble pops thus resulting in a low-probability event that produces large negative returns
4. Investor heterogeneity: Different investors have varying constraints when it comes to short-sales. The more bearish group of investors subject to short-sales constraints may just sell all their sales, a suboptimal solution, and thus their information is not fully included in the market

The oldest theory is focused on leverage effects. The idea is that a drop in prices raises operating and financial leverage thus exacerbating volatility. This theory is articulated by Fischer Black and Myron Scholes in 1973 "The Pricing of Options and Corporate Liabilities" in the Journal of Political Economy. Andrew A. Christie further explores the idea in "The Stochastic Behavior of Common Stock Variances--Value, Leverage and Interest Rate Effects" in the Journal of Financial Economics 1982.