Price Volatility and Market Frictions
STOCK MARKET VOLATILITY, Greg N. Gregoriou, ed., Chapman & Hall/CRC, April 2009
Posted: 21 Dec 2007 Last revised: 7 Mar 2012
Date Written: September 12, 2007
How market frictions affect price volatility is an important issue in finance. In this paper we propose a derivation of the price volatility in the model of Bayesian updates. We link price volatility to the fundamental (asset) volatility and the participation rate of the informed trader and derive an equilibrium ratio of informed and uninformed traders. This ratio depends on frictions, such as tick size. Our model predicts that price volatility increases as tick size is reduced, and vice versa. Because the all-familiar tests of NYSE (2000) and NASDAQ (2001) decimalizations are inconclusive, we explore this hypothesis using the Russian Federation bond data surrounding the event of 1000-fold re-denomination of the ruble in 1998. Results show that volatility of bond yields declines sharply after the increase in the tick size. This finding strongly supports the contention that market frictions affect price volatility.
Note: This paper is a new, significantly revised version of the Statistical Properties of an Informed Trading Model.
Keywords: Price volatility, market friction, informed trading, tick size, sovereign bonds
JEL Classification: G1, G14
Suggested Citation: Suggested Citation