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Do price limits and volatility get along together ?

, January 29, 2013, 0 Comments

In the last thirty years, volatility has been always of a major concern to the financial community. The main turning point that put the volatility importance forward is probably the crash of October  1987, commonly known as Black Monday. On Monday October 19th 1987, the Dow Jones Industrial Average dropped by 508 points, a daily drop of 22.61%, causing the halt of trading at the New York Stock Exchange. The crash also led to proposals for increased regulation to control price volatility and imposing price limits.

A vast literature has flourished to describe the behavior of volatility, starting with the seminal work of Engle in 1982 , extended by Bollerslev  to define the GARCH model.

Volatility in the African continent has some interesting microstructure features that always brought the interest of the financial community. Among these features, we can cite the summer effect, week day effect and Price Limits. In the African stock markets price limits vary from a country to another, but the average is usually between 5% and 20%. In this article, we will be looking at stock exchanges of the following countries : Tunisia, Egypt, Nigeria, Morocco and BRVM.


1.      Tunis Stock Exchange
The Tunis Stock Exchange was created in 1969. It is a private company that is owned by the 23 licensed stock brokers. There are 60 listed stocks with a market of capitalization of about 16 billion dinars ( 1.1 billion USD). The trading hours in a normal session ( by opposition of summer and Ramadan sessions) lie from 9 am to 2:10 pm, with a pre-opening session from 9 to 10 am, and pre-closing session from 2.00pm to 2:05 pm. During the continuous trading hours, i.e. from 10 am to 2 pm, trading is limited to a specific price window. First, at 10 am the opening price has to be within +/- 3 percent window of the previous closing price. Second, once a stock started trading, it can only trade within +/- 3 percent price window with respect to the opening price, beyond which trading is halted for 15 minutes and then both the ceiling and floor are increased by an extra 1.5 percent. This mechanism is repeated until we reach the +/- 6.09 percent limits with respect to yesterday’s closing.

2.      Egyptian Stock Exchange: Nilex
The Egyptian Stock Exchange (ESE) comprises two exchanges Cairo and Alexandria. Both governed by the same board and share the same trading, clearing and settlement systems. The Alexandria stock exchange was officially established in 1883, followed by Cairo SE in 1903. There are 381 listed stocks and a market capitalization of about 60 billion dollars. Stocks trading hours for a normal session last from 10.30 am to 2.30 pm.

In February 1997, ESE adopted the price limit tool in order to stabilize stock prices and minimize the losses due to high volatility in prices. All ESE stocks were subject to a 5 percent daily price limit. Since May 2002 however, ESE exempted some stocks from the price fluctuation limits. Among the main criteria for the company to have the price limit rule lifted are that 15 percent of the capital is free float and the stock traded for at least 220 days.  According the new trading halt mechanism, the stock price trades within an opening range of +/- 10 percent beyond which trading would be halted for 30 minutes. Then, the stock trades within the range of +/- 20 percent beyond which trading is suspended for the rest of the day.

3.      Nigeria Stock Exchange
The Nigerian Stock Exchange (NSE) founded in 1960. It has about 200 listed companies for a total market capitalization of about 50 billion dollars. Stock trading hours last from 10am to 4pm local time.

Price limits in Nigeria were set to be +/- 5 percent movements from yesterday’s closing. However, a few years ago, in order to curb the propagation of the global crisis, a number of measures were taken. One of those measures was the introduction of a 1  per cent maximum downward limit on daily price movement and 5 per cent on upward price movement. This was met with criticism from stakeholders, including operators in the market, on the basis that it was bias upwards and thus was not efficient and fair, and the price discovery process was distorted. This policy was later changed back to the 5 percent either way from the end October 2008.

More recently, since September 18 2012, the NSE introduced market making on sixteen blue-chip shares. Since it is difficult to make markets on tight margins, the daily price limits were increased from 5 percent to 10 percent.

4.      Casablanca Stock Exchange
The Casablanca Stock Exchange (CSE) was established in 1929 and currently has 17 members of about 80 listed stocks for a total capitalization of about 50 billion dollars. On a normal session, the trading hours last from 9am to 3h30 pm local time. Price limits in CSE are set to +/- 5 percent movements from yesterday’s closing.

5.      Bourse Régionale des Valeurs Mobilières (BRVM)
The BRVM is a regional stock exchange that includes the following West African countries : Benin, Burkina Faso, Guinea Bissau, Cote d’Ivoire, Mali, Niger, Senegal, Togo. Headquartered in Abidjan, the BRVM was founded in 1996,  has 36 listed stocks with a large dominance of securities from Cote d’Ivoire ( more than 85% of the stocks) and has a market capitalization of about 5 billion dollars. Price limits in BRVM are set to +/- 7.5 percent movements from yesterday’s closing.

The debate whether to have price limits or not is a long running debate that dragged the financial community for decades. Price limit advocates often claim that price limits decrease stock price volatility, counter overreaction, and do not interfere with trading activity.

However, we shouldn’t forget that price limits do cause several negative effects. The first negative effect is what is called volatility spillover. In fact, price limits could cause a higher volatility levels on subsequent days and hence will even exaggerate a phenomena that it is supposed to curb.

Second, price limits prevent prices from efficiently reaching their equilibrium level and cause what is called delayed price discovery phenomena. It becomes like those anesthetic medicines who instead of curing the disease will just make you forget about it.

Finally, price limits can interfere with trading. Trading activity indeed will be interfered with once asset prices hit limits. As a result, the trading activity in the subsequent trading days increase

Whether we agree on price limits or not, I think it is very important to address this issue carefully and to analyze its impact on volatility dynamics. A more flexible price limit system could be the solution to undermine the cost related to price limits and avoid the likelihood of improper price limit imposition.