Effectiveness Of Price Limits In Controlling Daily Stock Price Volatility: Evidence From An Emerging Market

Price limits are instituted to control the volatility of daily stock price movements through establishing price constraints and providing time for rational reassessment of investment decisions during times of panic trading. They function in a similar manner as the circuit breakers in the US exchanges. Advocates of price limits argue that establishing such limits will not interfere with trading activity on an exchange. On the other hand, opponents of price limits assert that these limits can be the source of higher volatility on subsequent trading days, or can delay full incorporation of information into prices, or can interfere with trading activities of investors. Previous research on the subject provides conflicting evidence (Kyle, 1988; Ma, Rao and Sears, 1989; Kuhn, Kurserk and Locke, 1991; Kim and Rhee, 1997).The objective of this paper is to examine the effectiveness of the price limit system employed at the Istanbul Stock Exchange (ISE)-an emerging market that has attracted a lot of attention from international money managers recently. The ISE is a fullyautomated, order-matching market. Such a system enables fast dissemination of information among investors (Naidu and Rozeff, 1994). Also, the trading takes place in separate morning and afternoon sessions. Thus, price volatility can be expected to be higher in such a market and price limits may help to control this volatility. Hence, with its characteristics, ISE provides an excellent platform for studying the impacts of price limits on stock price volatility.For analysis, daily stock price data for the period of January 2, 1995 to December 31, 1999 is used. During this time period, there are two types of price stabilization mechanisms employed by the ISE: tick size and trading session price limit. The tick size rule specifies the minimum allowable price change from one trade to the other and the tick size varies with the security price. The trading session price limit rule determines the maximum allowable percentage change in the price of a security during a session and this limit is ten percent during the sample period analyzed in this paper.For examining the impact of price limits, this paper performs two different tests. The first set of tests aims to determine whether hitting a price limit on a given day has an impact on the volatility of stock prices during the subsequent trading days. For this purpose, for a window of ten days around the limit day, the daily price volatility of stocks that hit the limit is compared to that of stocks that did not hit the price limit. The second set of tests is conducted to determine whether hitting a price limit on a given day has an impact on the volume of trading during the subsequent days. For these tests, over a ten-day event window, the daily volume of trading for stocks that hit the limit are compared to that of stocks that did not hit the limit.