Do price limits hurt the market?
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Do price limits hurt the market? Chia-Hsuan Yeh · Chun-Yi Yang
Received: 25 March 2012 / Accepted: 17 December 2012 / Published online: 4 January 2013 © Springer-Verlag Berlin Heidelberg 2013
Abstract Under an artificial stock market composed of bounded-rational and heterogeneous traders, this paper examines whether or not price limits generate the negative effects on the market. Through testing the volatility spillover hypothesis, the delayed price discovery hypothesis, and the trading interference hypothesis, we find that no evidence of volatility spillover is observed. However, the phenomena of delayed price discovery and trading interference indeed exist, and their significance depends on the level of the price limits. Keywords Price limits · Artificial stock market · Agent-based modeling · Genetic programming JEL Classification
D83 · D84 · G11 · G12
1 Introduction Price limit rules have been applied in financial markets for a long time. However, a consensus in terms of opinion has not so far been reached. Basically, the main reason why there are debates between the pros and cons is that they rest on different
C.-H. Yeh (B) Department of Information Management, Yuan Ze University, Chungli, Taoyuan 320, Taiwan e-mail: [email protected] C.-Y. Yang Department of Computational Social Science, Kransnow Institute for Advanced Study, George Mason University, Research I, CSC Suite, Level 3, 4400 University Drive, MSN 6B2, Fairfax, VA 22030, USA e-mail: [email protected]
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assumptions regarding the traders’ rationality. The proponents believe that traders are irrational and tend to overreact to market information. In fact, the empirical evidence found in Tversky and Kahneman (1974) upholds this argument. In this situation, asset prices exhibit large fluctuations, so that they deviate from their fundamental values. Appropriate financial regulations such as price limits can provide a cooling-off period for traders to reassess the intrinsic values of the asset, and help to curb traders’ irrational behavior. Such a reasoning is referred to as the overreaction hypothesis. If the imposition of price limits does succeed in inhibiting traders’ overreaction behavior, it is to be expected that price reversals will be observed in the following trading days after the limit moves, and price limits will thus help to improve the price discovery. Studies such as that by Ma et al. (1989) support the overreaction hypothesis. On the other hand, the opponents believe that traders are sufficiently rational and can process information efficiently, so that they are able to figure out the intrinsic values of the asset. In this case, the imposition of price limits will generate several negative effects. These effects are claimed by the information hypothesis (or the delayed price discovery hypothesis), the volatility spillover hypothesis, and the trading interference hypothesis. The information hypothesis claims that the main effect of price limits is to delay the process of price discovery. If
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