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

See all articles by Peter Lerner

Peter Lerner

Wenzhou-Kean University - Wenzhou Kean Business School

Chunchi Wu

SUNY at Buffalo - School of Management

Date Written: September 12, 2007

Abstract

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

Lerner, Peter and Wu, Chunchi, Price Volatility and Market Frictions (September 12, 2007). STOCK MARKET VOLATILITY, Greg N. Gregoriou, ed., Chapman & Hall/CRC, April 2009, Available at SSRN: https://ssrn.com/abstract=1076847

Peter Lerner (Contact Author)

Wenzhou-Kean University - Wenzhou Kean Business School ( email )

Kean University (ret.)
Wenzhou, China
Union City, NJ Wenzhou 07083
China

Chunchi Wu

SUNY at Buffalo - School of Management ( email )

Jacobs Management Center
Buffalo, NY 14222
United States

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