Abstract

There is no theoretical basis for determining whether the imposition of circuit breakers will have the desired effect of reducing stock market volatility. A commonly cited benefit ascribed to price limits is that such measures provide a cooling-off period, allowing investors to re-evaluate market information and to reformulate a new investment strategy. Another benefit is that price limits allow order imbalances to be publicized and that therefore they work to attract value traders. In both these ways, proponents claim, price limits protect the market from violent movements. Opponents of price limits argue that they serve no purpose other than to slow down or delay a price change. They argue that even though price limits can stop the price of a share from free falling on the trading day when a shock hits, the price will continue to move toward equilibrium as new limits are established in subsequent trading periods. According to this view, price limits only prolong the number of trading days it will take for the market to adapt to a disturbance toward equilibrium. Given the above diverse viewpoints, the effects of price limits is an issue to be empirically tested. Employing a projected standard deviation series with heteroscedasticity corrected as a measurement for stock volatility, and using both daily and monthly data, we test the hypothesis that a narrower price limit will curtail price fluctuation. Our results do not show that price limits have a significant impact on reducing equity price volatility. On the contrary, we find that price limits tend to slightly exacerbate price volatility. We also find that serial correlations of stock returns are inversely related to the range of price limits, implying a delaying effect of price limits.

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