Can a stochastic cusp catastrophe model explain stock market crashes?

This paper is the first attempt to fit a stochastic cusp catastrophe model to stock market data. We show that the cusp catastrophe model explains the crash of stock exchanges much better than other models. Using the data of U.S. stock markets we demonstrate that the crash of October 19, 1987, may be better explained by cusp catastrophe theory, which is not true for the crash of September 11, 2001. With the help of sentiment measures, such as the index put/call options ratio and trading volume (the former models the chartists, the latter the fundamentalists), we have found that the 1987 returns are bimodal, and the cusp catastrophe model fits these data better than alternative models. Therefore we may say that the crash has been led by internal forces. However, the causes for the crash of 2001 are external, which is also evident in much weaker presence of bifurcations in the data. in this case, alternative models explain the crash of stock exchanges better than the cusp catastrophe model. (C) 2009 Elsevier B.V. All rights reserved.