Raising Price Limits

There is a huge debate among policymakers, market participants and academics regarding the effectiveness of price limits or trading halts. Broad literature suggests that price limits do not enhance market efficiency but impose severe costs; especially narrower price limits exhibit higher acceleration rate, i.e. markets document high frequency of upper and lower stock hit-days with narrower price bands. Prior to the change in circuit breaker regime, Pakistan had the most narrow price limits at 5%. In Taiwan, Malaysia and Saudi Arabia, the scrip-wise price bands are 7.5, 15, and 10%, respectively. In many developed financial exchanges, the security-wise price bands have been abolished and only caps are imposed on benchmark indices if they rise or fall by 5%.

From the market volatility perspective, there is a growing debate on enforcement of price limits. The volatility spillover hypothesis mentions that price limits increase the volatility on the subsequent trading days, because the circuit breakers prevent large one-day price changes and immediate corrections in order imbalance. The imposition of price bands does not contain volatility but it only postpones it. Thus, markets observe extreme volatility, once markets resume normal trading after cool-off period or on the next trading day. However, the major justification provided by securities’ market regulator(s) on the need of enforcement of circuit breakers is to inhibit the extreme price movements. Hence:

“A policy question that is often raised is ‘If price limits are to be adopted, then what is the appropriate level?’ In fact, conventional wisdom even suggests that wide price limits may be harmless.”

Lastly, to answer the afore-stated question and to understand how the market is performing after phase-wise enhancement of price bands, the data for KSE All-Share Index was divided into two sample periods, i.e., pre-period, from Monday December 2, 2019 to Friday January 17, 2020 (when 5% limits were imposed) and post-period from Monday January 20 till Friday March 6, 2020 (when price limits were enhanced by 0.5% every fifteen days from 5.5% to 6% to 6.5% till 7.5%). Here only three stock market variables were considered for comparison (i.e. one indicator for liquidity and two indicators for volatility). The daily average for one and a half months between pre- and post-period liquidity (turnover) and volatility (difference between high and low index values) – standard deviation of KSE All Share index returns, comparison is shown in the Table.

The afore-stated figures surprisingly show that the average daily turnover following the regime change has declined significantly (contradictory to the expectation/evidence of higher liquidity in the post-period with broad price bands); similarly, both measures of volatility have slightly increased following the enhancement of circuit breakers (which was expected due to enhancement of circuit breakers). Two things need to be put in perspective before interpreting the results: a) the post-period shows only gradual enhancement of price bands and not showing full impact of maximum 7.5% enhancement; and b) after the policy shift, Pakistan’s economy encountered few adverse events, such as, record inflation of 14.6% in the month of January (announced in February 2020), tension between SECP and PSX on the policy of new brokers’ regime, and threat of novel coronavirus. Thus, the expected benefits of price cap enhancements, especially in case of trading volumes are not observed due to negative macro-economic factors, and hence the evidence of efficiency becomes clearer in the medium to long run period.

Thus the policy question of raising price limits and its level of appropriateness is still unanswered in case of financial exchange in Pakistan.