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An Extreme Value Approach to Test the Effect of Price Limits on Volatility

Haitham Nobanee1

College of Business Administration, Abu Dhabi University, P.O. Box 59911, Abu Dhabi, United Arab Emirates. E-
mail: nobanee@gmail.com;Tel: +971 2 5015709; Fax: +971 2 5860184

Khalil Hilu
College of Business Administration, Abu Dhabi University, P.O. Box 59911, Abu Dhabi, United Arab Emirates. E-
mail: khalil.al-hilu@adu.ac.ae;Tel: +971 3 7090755; Fax: +971 2 5860184

Citation:

Nobanee, H. , K. Hilu. (2013). An Extreme Value Approach to Test the Effect of Price
Limits on Volatility. Journal of Modern Accounting and Auditing, 9(10), 1382-1391.

Abstract

Many stock exchanges around the world enforce daily price limits on the amount asset prices can

change to prevent the market from overreacting and to reduce volatility. Using a methodology of

comparing volatility based on the Extreme-Value technique, we empirically investigate the

impact of price limits on the volatility of the Stock Exchange of Thailand. Our empirical results

support price limits advocates suggesting that price limits moderate stock price volatility.

Code JEL: G10, C53

Keywords: Price Limits, Extreme value theory, Volatility, Stock Exchange of Thailand

1 Correspondence author
1. Introduction

After the stock market crash of October 1987, there were widespread concerns and debates about

the causes of the crash and whether the microstructure of the equity market should be closely

monitored to prevent markets from experiencing such huge fluctuations. Circuit breakers have

been recommended as a tool for market stabilization. Circuit breakers are mechanisms designed

by stock exchanges to stop trading or restrict price movement in order to stabilize the market

during large sell-offs. They are also used to cool down markets during times of panic. The most

common and perhaps most primitive circuit breaker method is the setting of price limits. Price

limits are artificial boundaries set by market regulators that restrict price changes of a stock to a

pre-specified range during a trading day or a single trading session. Price limits are usually

settled as a percentage change from the closing price of the previous day or trading session.

During a price limit hit, stock price is prevented from moving upward or downward beyond the

maximum daily price variation range.

Daily price limits rules are applied in many stock markets around the world, especially in Asian

and European stock markets, including Austria, Belgium, France, Italy, Japan, Korea, Malaysia,

The Netherlands, Spain, Switzerland, Taiwan, and Thailand. Daily price limits are also used in

the US futures markets. Many stock exchanges have used several price limits rules in order to

find the advantages of each. For example, the Stock Exchange of Thailand raised their daily price

limits from 10% to 30% at the end of the year in 1997. The Taiwan Stock Exchange has applied

twelve different daily price limits rules since 1962; its most recent change was from 7% to 3.5%

in 1998. The Korean Stock Exchange switched from absolute value daily price limits rules to a

percentage change price limit in 1995, and since that date price limits have increased from 4.6%

to 15% in four stages. The two Chinese stock markets (the Shanghai Stock Exchange and the
Shenzhen Stock Exchange) did not use any price limits rules until 1996, when both markets

adopted a 10% daily price limit. The Tokyo Stock Exchange moderated their absolute value price

limits rules in 2000.

The primary aim of price limit rules is to stabilize the markets during panic trading, to moderate

vitality by repressing excessive speculation, and to allow stocks to be traded at prices close to

their fair value. However, their impact on the market is a somewhat unresolved issue (Harris,

1998). Most government regulators, market participants, and academic researchers believe that

price limit rules moderate stock prices’ volatility, however, others believe that price limits are

ineffective, costly, or could create more problems than they could solve. These differences of

opinion and current arguments about the effectiveness of price limits in curbing excess volatility

motivate the preparation of this paper. Proponents of price limits claim that they prevent extreme

price movements in two ways. First, price limits literally set a ceiling and a floor for the range in

which the price can move within a trading day. Second, price limits provide a cooling-off period

that allows investors to revaluate market information, which prevents irrational reactions during

periods of extreme price changes. (see Yeh and Yang,2010,:Kim and Yang, 2008;Anderson,

1984; Wei and Chiang, 2004;Arak and Cook, 1997; Greenwald and Stein, 1991; Ma, Roa and

Sears, 1989a, 1989b; Chou et al., 2000; Lee and Kim, 1995; Kim and Rhee, 1997; Lee and

Chung, 1996; Bernstein, 1987; Brennan, 1986; Koders, 1993) Other proponents claim that by

providing a “time-out,” price limits facilitate price discovery, allow traders to pause and evaluate

stock prices, and allow for publicizing order imbalances to attract value traders and cushion

violent movements in the market. Price limits are also said to reduce the potential default risk

(see Brennan, 1986; Moser, 1990; Ma et al, 1989b) and counter overreaction, without interfering

with trading activity (Cho et al, 2003).


On the other hand, critics of price limits insist that they reduce market liquidity. This problem

with price limits is also identified as the trading interference hypothesis: According to this

hypothesis, when daily price limits prevent trading, stocks become less liquid, which artificially

interferes with trading activity on the day of the limit hit and subsequent days. (See Wei and

Chiang, 2004; Fama, 1989; Telser, 1989; Lehmann, 1989; Lauterbach and Ben-Zion, 1993; and

Kim and Rhee, 1997). Price limits rules could delay the price discovery process by preventing

prices from effectively reaching their equilibrium level (See Fama, 1989; Lehmann, 1989; Lee et

al., 1994; Figlewski, 1984; Kim and Rhee, 1997; Meltzner, 1989; Miller et al., 1987; Telser,

1981; Lee and Kim, 1995; Ma et al., 1989a, 1989b; Chiang et al, 1997; Kim and Rhee, 1997).

Another potential effect of trading interference through price limits is weakened market

efficiency (Fama, 1989; Lehmann, 1989; Lee et al, 1994). Price limits may cause volatility to

increase rather than decrease on subsequent trading days—according to the volatility spillover

hypotheses—because limits prevent large one-day changes, and prevent immediate correction in

order imbalance (See Kim and Rhee, 1997; Lehmann, 1989; Fama, 1989; Kyle, 1988; Kuhn et

al., 1991; Lee and Kim, 1995). Kim and Sweeney (2000) also argue that price limits can affect

trading behavior on non-limit hit days. In their model, informed traders strategically time their

trading, taking the existence of price limits into account. In short, proponents of price limits rules

suggest that price limits protect the market during excess noise trading, while opponents of price

limits argue that they serve no purpose other than interfering with the market and slowing down

price adjustments to their true values. Given that there is no perfect way of examining whether

price limits rules will have the desired effect, the whole argument becomes an empirical issue

(Chen, et al, 2005). Imposing price limits rules produces another costly problem: Price limits lead

to unobservable events. That is, when stock prices hit the limits, we cannot observe the true
equilibrium prices that day. This will lead to a biased estimation of variance and underestimates

of volatility. Well-established volatility analytical models such as a mean variance analysis or

GARCH modelling may create biased estimations of volatility. Ignoring limit hit events or

deleting prices on limit hit days will also bias volatility estimations (Wei and Chiang, 2004:

Hsieh and Yang, 2009, Hsieh et al., 2009). Some papers have applied event study methodology to

test the effect of price limits on volatility where successive limit hits are omitted from the

analysis, which affects the accuracy of the results ( Kim, 2001). In this study, we examine the

effect of price limits on the volatility of the Stock Exchange of Thailand. It moved from a highly

restricted price limits regime to more relaxed price limits: the first regime had 10% price limits,

and the second regime applied more relaxed 30% limits at the end of the year in 1997. We apply

an Extreme Value approach in this paper to test for the effect of price limits rules on volatility.

The rationale behind using this approach is that applying price limits rules may cause volatility to

spillover across a longer period of time, which could affect the tails of the distribution of stock

returns. In the presence of price limits rules, stock prices move slowly to their fundamental

values. However, in the absence of price limits, stock prices are expected to react immediately to

new information. In this study we hypostasize that restricted price limits rules moderate volatility

(AlShattarat et al, 2009; Maghyereh et al, 2007; Nobanee, 2007; Nobanee and Alhajjar, 2009;

Nobanee et al, 2010).

We organize the reminder of this paper as follows. In the next section we outline our test design.

In Section 3 we describe our data and present the summary statistics. Finally, we present the

estimation results in Section 4 and conclude in Section 5.


2. Test Design

The econometric approach used in this research is relatively straightforward. However, some

conceptual review on extreme-value theory may be helpful in understanding its basic constructs.

Sometimes extreme movements in stock prices call for extreme measures. Periods of market

collapse, and economic and financial crises, have increased the need to quantify volatility and

assess the probability of extreme movements of stock prices. Quantification of these extreme

price movements is particularly important for markets that impose price limits. Extreme Value

Theory provides a comprehensive theoretical foundation on which statistical models describing

extreme variables can be shaped (Allen et al, 2011a,b,c). Stock price movement is a random

variable, so the potential values follow a probability distribution. Extreme events occur when

stock price movements show values from the tails of the distribution. The distinguishing feature

of Extreme Value Theory is that it provides the best possible quantification estimate of the tail

area of the distribution of stock returns (Allen et al, 2011a). Extreme Value Theory accounts for

the limiting distribution of the extreme values of a random variable, instead of the probability

distribution (Gravelle and Li, 2011). Even though “fat–tailed” random variables could follow

numerous probability distributions under Extreme Value Theory—such as a stable Paretian or

mixtures of normals—at the limit these numerous distributions converge into a single underlying

distribution (Allen et al, 2011a).

In this study, two classes of extreme value distribution are used to find the appropriate limit hits

distributions. The first class was inspired by Jenkinson (1955), and includes three standard

extreme value distributions: Fréchet, Weibull, and Gumbel. The second class is the Generalized

Pareto Distribution.
To motivate the estimators used, suppose that X  l , u  is a random variable with density f and

cdf F . Consider X 1 , X 2 , ..., X n to be a sequence of stock price changes on days 1,2,..., n with a

probability density function of F . Extremes are defined as the maxima and minima of the n

stationary random variables X 1 , X 2 , ..., X n . Let X max,n represent the highest daily price changes (the

maximum) and X min,n indicate the lowest daily price changes (the minimum) over n trading days:

X max,n  max( X 1 , X 2 , ... , X n ) 1a 


X min,n  min( X 1 , X 2 , ... , X n ) 1b 

The two extremes, the maximum and minimum, are connected by the following relation:

X min,n  min( X 1 , X 2 , ..., X n )   max( X 1 , X 2 , ..., X n ) 2

As shown by Gumbel (1958), if the variables X 1 , X 2 , ..., X n are statistically independent and drawn

from the same distribution, then the exact distribution of the maximum and minimum can be

written as a function of the parent distribution F x  and the length of the selection period n . The

exact distribution of X max,n is H max,n x   F x n and the exact distribution of X min,n is

H min,n x   1  1  F x  .
n

It can be easily shown that the exact distribution of the extreme observation is degenerate in the

limit. In order to find a distribution of maxima which is non-degenerate, the Fisher-Tippett

(1928) theorem shows that the variate, X max,n , can reduced to a location parameter,  max,n , and to a

scale parameter,  max,n . As a result:


x  X max,n   max,n  /  max,n  H max ( x) .
d

Assuming the existence of a sequence of such parameters, Gnedenko (1943) obtains the

following three types of non-degenerated distributions for the standardized maximum, H max x  :

Gumbel : H max,0 x   exp  exp x , for    x  , 3a 



exp   x  m ax

 for x  0,
Weibull : H max, x     max  0, 3b 
1, for x  0

0, for x  0,

Frechet : H max, x     max  0 3c 


exp  x
 m ax
, for x  0,

where  max is the tail shape of the parent distribution. The above families of extreme value

distributions can be nested into a single parametric representation, as shown by Jenkinson (1955).

This representation is known as the "Generalized Extreme Value” distribution, and is

given by


H max, x,  ,    exp 

exp  1   max x  max
1 / 
 if  max  0,
4
exp exp x 
 if  max  0,

where  max is called the shape parameter. When  max  0 , we get the Fréchet distribution, which

incorporates fat-tailed distributions such as Student's t or the Stable Paretian distributions. If

 max  0 , there is the Gumbel distribution, which describes thin-tailed distributions like the

normal or log-normal. When  max  0 , we get the Weibull distribution, which describes

distributions without a tail, but a finite end-point, such as the uniform and the beta distribution.

The shape parameter  , called the tail index, reflects the weight of the tail of the distribution of
the parent variable X , whereas the parameters of scale,  , and of location,  , represent the

volatility and the average of the extremes, respectively.

The second approach that can be used to determine the type of asymptotic distribution of

extremes is based on the concept of Generalized Pareto Distribution. Using the Pickands-

Balkema-de Haan theorem , excess over threshold can be modeled by the Generalized Pareto

Distribution (McNeil and Frey, 2000), which can be derived using the Generalized Extreme

Value distribution (Balkema and De Haan, 1974; and Pickands, 1975). The Generalized Pareto

Distribution of the standardized maximum variable (symbolized by Gmax x  ) is given by

Gmax x   1 logH max x  , where H max x  is the Generalized Extreme Value distribution:

1  1   max x /  max
1 / 
 if  max  0,
Gmax,  x,  ,     5
1  exp x / 
 if  max  0,

where   0 , and the support of x  0 if  max  0 and 0  x   /  max if  max  0 . Clearly, the

tail index  max from the Generalized Extreme Value is the same as for the Generalized Pareto

Distribution. The density of the Generalized Pareto Distribution can be easily derived as


 1/  max    max x   max 1
1
 max  0,
g max, ,  x    6
 exp x / 
  max  0,
1

It is worth noting that the Generalized Pareto Distribution in Eq. 5 covers the Standard

Pareto distribution, the uniform distribution on  1,0 , and the standard exponential distribution:

Pareto : G max, x   1  x 1 /  m ax for x  1, 7a 


G max, x   1   x  for x   1,0, 7b 
1 /  m ax
Uniform :
Exponential : G max, x   1  exp  x  for x  0. 7c 
When  max , the distribution’s tail decreases polynomially: Pareto. When   0 , the tail decreases

exponentially: exponential. Finally, for   0 , the distribution is short tailed: uniform.

In order to find the parameters of the asymptotic distributions, we use the Maximum Likelihood

method2, a parametric approach that provides efficient parameter estimates of the extreme value

distributions (O’Hagan and Stevens, 2002a ,b), Smith (1985) has also shown that maximum

likelihood estimates of the extreme value distribution parameters are consistent and

asymptotically normal as n   . Using the density function for the Generalized Pareto

Distribution,

 
1
1  
1

 1  x  max   m ax   x  max   m ax  x  max
1    exp 
   1     where 1   max  0, max  0,
  max
  max
  
      
hmax, ,  ,  x    8
max max max max
 
  x   m ax

 1 exp  x  max  e  m ax  if  max  0.
 max   max 
  

we can obtain the log-likelihood function as follows:

n
Lmax ( ,  ,  )   hmax, ,  ,  x     x   max  
x  9
i 1 1 max    0 
   max  

Using a Maximum Likelihood method, the various parameters can now be estimated by a

numerical optimization of the (log) likelihood.

2
There are other methods for estimating the parameters of the extreme value distribution. Details about these
methods can be found in Leadbetter et al., (1983), Smith (1985), Longin (1996), and Embrechts et al., (1997).
3. Data and Summary Statistics

The data used in this study were daily price indexes of the Stock Exchange of Thailand during the

period 1990-2004. The data was obtained from the DataStream. Our sample period included two

price limits regimes. The first regime was applied between 01/01/90 and 31/12/97 with daily

price limits of 10%. The second price limits regime, applied between 01/01/98 and 31/12/04, set

daily price limits of 30%. Table 1 provides summary statistics of differences in the log of the

stock index during the two price limits regimes. As the table below shows, the univariate

statistical measures exhibit major differences between the two limits regimes.

Table 1
Summary Statistics
Sample Size (N) Mean Max. Min. Std.Dev. Skewness Kurtosis Normality
Regime I 2087 -0.0004 0.087 -0.072 0.014 -0.081 7.740 1956.056***
Regime II 1827 0.0003 0.133 -0.100 0.019 0.524 7.384 1546.848***
Note: Jarque-Bera (1980) test for normality is used here and indicates non-normal data. *** indicates significant at 1% level.

We define the extremes as changes beyond high thresholds. The daily price changes below the

threshold are called minimal changes, and those above the threshold are called maximal changes.

We set the threshold as two standard deviations around the sample mean of the daily price

changes, which corresponds to almost 2% of the right and left tails of the distribution. Table 2

displays the summary statistics of the extreme values for the two regimes. The summary statistics

of Table 2 clearly show that the extreme values are increased substantially when moved to a less

restrictive price limits regime. The summary statistics of Table 2 indicate that the extreme

movements within more restrictive price limits are smaller than the extreme movements with less

restrictive price limits.


Table 2
Summary Statistics of Extreme Daily Price Changes
Panel A: Local Maxima
Sample Size (N) Mean Max. Min. Std.Dev. Skewness Kurtosis Normality
Regime I 166 0.034 0.086 0.020 0.015 1.748 5.788 138.380***
Regime II 302 0.033 0.133 0.020 0.016 2.355 9.220 512.448***
Panel B: Local Minima
Sample Size (N) Mean Max. Min. Std.Dev. Skewness Kurtosis Normality
Regime I 188 -0.033 -0.020 -0.092 0.015 -1.860 6.275 192.572***
Regime II 384 -0.031 -0.020 -0.100 0.012 -2.340 10.264 572.554***
Note: Extreme values of daily returns changes are defined as excess over the threshold, which is set as the two standard deviation around the
sample mean of the changes in log of the stock index. Jarque-Bera (1980) test for normality is used here and indicates non-normal data. ***
indicates significant at 1% level.

4. Estimation Results

Table 3 reports the Maximum Likelihood estimates of the Generalized Extreme Value

distribution for each of the price limits regime series. As expected, it indicates that extreme

movements for both the maximum and minimum changes in stock prices for all series were

created from Fréchert extreme-value distribution. In all cases, the maximum likelihood estimates

of the Generalized Extreme Value distribution show that the tail index (  ) is positive and

statistically different from zero. For the maximum changes in stock returns, the estimated tail

index (  max ) is found to be 0.4670 for regime I and 0.3695 for regime II, while for the minimum

changes, the estimated tail index (  min ) is found to be 0.4345 for regime I and 0.3028 for regime

II. From these results, we can see that lower values of shape parameters are generated in the less

restrictive price limits (regime II) period. This implies that large price changes are highly

probable during a restrictive price limits period.

The maximum likelihood estimates of the Generalized Extreme Value distribution show that the

volatility of maximal and minimal changes, measured by the scale parameters  max and  min ,

increases significantly as we move from Regime I to Regime II. When price limits are relaxed

from 10% to 30% we find that volatility increases from 0.0076 to 0.0092 for the maximal
changes and from 0.0165 to 0.0202 for the minimal changes. These results indicate that the Stock

Exchange of Thailand will be less volatile in a more restrictive price limits regime.

Table 3
Maximum Likelihood Estimates of Generalized Extreme Value
Panel A: Local Maxima
 max  Max  max Log-L
Regime I 0.0261*** 0.0076*** 0.4670** 1272.981
(0.0009) (0.0001) (0.0361)
Regime II 0.0250*** 0.0092*** 0.3695** 1211.809
(0.0007) (0.0009) (0.0187)
Panel B: Local Minima
 min  min  min Log-L
Regime I -0.0379*** 0.0165*** 0.4345*** 1367.806
(0.0001) (0.0008) (0.0064)
Regime II -0.0351*** 0.0202*** 0.3028** 1324.820
(0.0001) (0.0003) (0.0352)
Note: P-values are given in parentheses. Log-L is the maximum log-likelihood values. ***, **, and * denote significant at 1%, %5, and 10%
levels, respectively.

Table 4 shows the maximum likelihood parameters estimates of the Generalized Pareto

Distribution. According to the P-values given in the table, the parameters of the Generalized

Pareto Distribution are statistically significant from zero. The estimated shape parameters for

minimal values (  min ) are greater than those of the maximal values (  max ). For both the minima

and maxima changes, the volatility of extremes increases significantly as we move from Regime I

to Regime II. These results confirm the above conclusion that the stock market is less volatile in

more restrictive price limits regimes. Therefore, we feel confident in our conclusion that

restrictive price limits moderate volatility in the Stock Exchange of Thailand.


Table 4
Maximum Likelihood Estimates of Generalized Pareto Distribution
Panel A: Local Maxima
 max  Max  max Log-L
Regime I 0.0192*** 0.0156*** 0.2971** 1356.492
(0.0001) (0.0002) (0.0380)
Regime II 0.0254*** 0.0992*** 0.3140** 1304.071
(0.0066) (0.0001) (0.01334)
Panel B: Local Minima
 min  min  min Log-L
Regime I -0.0439*** 0.0369*** 0.5776* 1302.915
(0.0045) (0.0066) (0.0651)
Regime II -0.0474*** 0.0552*** 0.5525* 1298.704
(0.0003) (0.0007) (0.0869)
Note: P-values are given in parentheses. Log-L is the maximum log-likelihood values. . ***, **, and * denote significant at 1%, %5, and 10%
levels, respectively.

5. Conclusion

The effect of price limit on volatility has been studied extensively, particularly after the 1987

market crash. The common view among regulators and academics is that restrictive price limits

rules curb share price volatility. Daily price limits allegedly control volatility by establishing

price constraints and providing time for rational reconsideration during times of panic trading.

Despite this rationale for price limits, research confirming this beneficial aspect is lacking.

Through an application of the extreme- value analytical method, we find that the Stock Exchange

of Thailand is less volatile when the price limits are more restrictive. Therefore, we can conclude

that price limits are effective in reducing volatility of the Stock Exchange of Thailand.

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