Investigation of the Effects of Price Limit Changes on the Intraday Volatility of Iran’s Stock Market Using Realized Variance (RV) and District Fourier Transform (DFT)

Abstract

In this paper, the effect of a change in price limit on Iran’s stock market and its volatility was studied by applying two methods. One was Realized Variance (RV) before and after the price change was applied and the other was District Fourier Transform (DFT), which was applied to intraday price changes before and after changes occurred to the price limits so that the volatility could be studied at different frequencies. Using RV, it was found that the effects of a price limit change on all the markets and industries were not the same. As we witnessed, a change from a limit of ±10% to ±3% in the yellow market actually resulted in a more volatile market, while a change from a limit of ±10% to ±2% in the orange market did not result in a significantly more volatile market. The results of DFT showed that a tighter price limit increased the volatility; however, the effects were not the same at different frequencies. In conclusion, narrowing the price limit did not necessarily result in a decline in intraday volatility. Even in some cases, severe narrowing of the price limit could lead to an increase in the intraday volatility of stock prices.Keywords: Price Limit, Intraday Trades, Trade Halts, Realized Variance (RV), District Furrier Transform (DFT). IntroductionIn inefficient markets, prices are not always a true reflection of value. Therefore, law-makers and some scholars suggest using price limits and trade halts as a method of controlling severe volatilities and preserving a fair trend in the market. It has always been a challenge for law-makers whether or not to use price limits and no consensus is present among professionals and law-makers about the usage of these tools. Price limits are set in a way to prevent trades outside of a predetermined price. Price limits have two main characteristics that make them effective, firstly, by imposing a legal limitation on trading on prices outside a limit and secondly, by creating a lag, in which investors can have a time to reassess their decisions. As there is no consensus on the effects of price limits, there have been numerous changes in the policy. When the price limits of different markets in Iran’s Fara Bourse (IFB) was changed from 10% to tighter 2 and 3%, the unique chance of studying the effects of price limits on volatility was presented. In this paper, we tried to shed light on the relationship between price limits and intraday volatility in Iran’s stock exchange and investigated whether tightening the price limit would lead to a less volatile market or not. Method and dataIn this study, intraday trade data for a last price of 1-minute intervals was obtained in a two-year time period consisting of one year before and one year after the change in the price limit. Then, the new price limit was set in September of 2018 so that the dataset ranged from September 2017 to September 2019. This study used two methods to analyze the effect of a change in price limit on market volatility. In one analysis, Realized Variance (RV) for each day of each stock was calculated before and after the change in the price limit and then, changes in the RV were investigated by using a T-test.In the second method, to further study the changes in volatility, District Fourier Transform (DFT) was applied to the time series before and after the change in the price limit, resulting in an amplitude vector with 105 elements for each stock. Each element presented the amplitude of a specific frequency of volatility. By comparing the changes in each frequency before and after the price change, the effect of the price limit change on volatility could be further studied. FindingsThe results from both methods showed a similar pattern suggesting that a narrower price limit did not always result in a change in market volatility. A reduction from a symmetric price limit of 10% to 3% actually resulted in a more volatility market; however, further narrowing of the price limit to a symmetric price limit of 2% did not result in a significant change in the market volatility. ContributionTo reach a consensus on the matter of effectiveness of price limits and trade halts, this research focused on how these tools could affect intraday volatility. As a more volatile market with narrower price limits could have negative effects, such as weakening the effects of market makers, this research showed how policy makers had to take a possibly more volatile market into account when deciding to impose a narrower price limit, thus paving the way for further studying the negative effects of price limits, especially in the case of narrowing them. Conclusion and discussionIt was witnessed that a decrease in price limit to a symmetric limit of 3% from a symmetric limit of 10% resulted in a more volatile market. Further narrowing of the price limit to a symmetric limit of 2% did not indicate a significant change in volatility. This finding was especially notable when confirming that imposing price limits did not always result in the intended outcomes expected by the law-makers. This increase in volatility could be considered as an undesirable consequence of narrowing the price limit, which had to be taken into consideration by the law-makers before imposing such changes. To evade such effects, law-makers could consider applying methods like smart price limits.Accordingly, it can be suggested that future studies be conducted to investigate whether or not the undesired effects of price limits get more intense as the price limits get narrower. Also, after this study was performed, Tehran’s Stock Exchange (TSE) experienced a gradual expansion of the price limit from a symmetric limit of 5% to 7%. Each of these changes suggest an opportunity for conducting further research on the effects of price limit changes.

Keywords

• price limit
• intraday trades
• trade halts
• realized variance (rv)
• district furrier transform (dft)