A type of risk that relates to severe drops in an entity’s stock price in an active market. As a result, the market capitalization of an entity also decreases in the same proportion, leading to a negative effect on its ability to continue, and conduct business as usual.

With the possibility of a stock’s price falling dramatically over a short period, crash risk may also dramatically increase. In general, crash risk results from unfavorable movement in a stock price (or equity investment value) in a downside direction (and hence it involves a certain deal of a downside risk). Such movement may happen due to multiple factors including firm-specific and market specific ones. Firm specific factors may take the form of negative information or the attempts of management to hide negative information, etc. Stock liquidity and industry pressures may also play a part.

In theory, stock price crash risk may be assumed to result from the negative behavior of managers, corporate governance system, and disaccord among investors (particularly blockholders), and particularly cases of information asymmetries between corporate insiders and external stakeholders.

The potential impact of stock liquidity on crash risk is determined based on two conflicting theories- namely, governance theory and short-termism theory. Governance theory holds that stocks with high liquidity are expected to feature lower crash risk. In contrast, short-termism theory hypothesizes that stocks with high liquidity will experience crash risk due to the impact of short term fluctuations/ swings on stock prices (short termism).

In the context of risk management, stock price crash risk is also defined as the conditional skewness of return distribution, reflecting the asymmetry in risk associated with an investment or position. This measure of risk is important for investment decisions and risk management.