RECONSIDERING PRICE LIMIT EFFECTIVENESS

• DOI: http://doi.org/10.1111/jfir.12021
• Author: Kenneth A. Kim,Haixiao Liu,J. Jimmy Yang
• Published date: 01 December 2013
• Date: 01 December 2013

RECONSIDERING PRICE LIMIT EFFECTIVENESS

Kenneth A. Kim

Renmin University of China

Haixiao Liu

Yanshan University

J. Jimmy Yang

Oregon State University

Abstract

We study China’s experience with price limits by comparing a period with price limits to

a period without price limits. Although many prior studies document costs of price limits,

we show benefits of price limits. We find that price limits can facilitate price discovery,

moderate transitory volatility, and mitigate abnormal trading activity. A tighter price limit

for poorly performing stocks can also moderate volatility. We do not find evidence of a

magnet effect, which suggests that prices gravitate to limit prices. Finally, we find

evidence that price limits can facilitate market recovery following crashes.

JEL Classification: G10, G14

I. Introduction

For the first time in its history, the United States is imposing price limits on individual

stock prices. On May 31, 2012, the Securities and Exchange Commission (SEC)

announced a new price limit regulation (effective April 8, 2013) known as the Limit Up–

Limit Down rule. Under this regulation, if incoming orders place a stock price 5% above

or below its average price from the preceding five minutes, the order goes unexecuted and

afive‐minute trading halt follows.

1

The SEC’s rationale for imposing price limits is that

they supposedly give traders time to assess whether any large price moves are based on

We thank the journal’s editors, associate editor (Kumar Venkataraman), and anonymous referee for their

overall handling, overseeing, and reviewing of our paper. We also thank Haiwei Chen, Pin‐Huang Chou, Yong Kim,

Haithan Nobanee, Roberto Pascual, David Reiffen; seminar participants at the University of New South Wales,

University of Sydney, National Sun Yat‐Sen University, National Chung‐Hsing University, National Kaohsiung

First University of Science and Technology; and session participants at the 2011 Asian Finance Association and

2011 Financial Management Association meetings for comments and suggestions on earlier versions of this paper.

We also thank Shane Corwin for answering our questions on estimating spreads using daily data. Kim gratefully

acknowledges the PACAP Research Center (in particular, Shaw Chen and Tong Yu) for generously providing data

and technical support. The usual disclaimer applies.

1

The 5% price limit is applied to S&P 500 stocks, Russell 1000 stocks, and certain exchange‐traded products.

For other stocks, the price limit is 10%. For more specific details of the Limit Up–Limit Down regulation, see http://

www.sec.gov/rules/sro/nms/2012/34‐67091.pdf.

The Journal of Financial Research Vol. 36, No. 4 Pages 493–517 Winter 2013

493

© 2013 The Southern Finance Association and the Southwestern Finance Association

fundamentals. We study regulatory price limits imposed in China’s stock markets, which

are used on a day‐to‐day basis, to provide insights into price limit effectiveness.

Although the United States is new to imposing price limits on individual stock

prices, it is a fairly common feature in most stock exchanges around the world. According

to Kim and Park (2010), during their study period, 23 of the world’s 43 largest stock

exchanges impose daily price limits on individual stock prices. For example, on any given

trading day on China’s stock exchanges a stock price cannot change by more than 10%

from its previous day’s closing price. The primary rationales for using daily price limits,

from various stock exchanges that impose them, are generally consistent with the SEC’s

rationale for trying them: price limits are posited to moderate excessive volatility, mitigate

panic behavior, and provide time for reassessment (e.g., Kim and Rhee 1997; Kim 2001;

Kim and Yang 2004). However, for more than a decade, academic researchers have found

evidence of costs to imposing price limits. According to many studies, price limits impede

market efficiency while showing no evidence of achieving their intended objectives (see

Kim and Yang 2004 for a thorough literature review of price limit studies).

We reevaluate price limit effectiveness by studying a market that experienced

trading with and without price limits and find benefits to price limits. During 1992–1996,

China’s stock markets did not use daily price limits (we refer to this period as the no‐PL

regime). Other than this period, the Chinese markets have always imposed price limits.

China’s experience with price limits is useful from a research standpoint. A major

shortcoming of all existing price limit studies is that they are unable to ascertain reliably

whether the markets would be better off without price limits (see Harris 1998; Kim and

Yang 2004 for discussions). That is, prior researchers who study markets with price limits

are unable to know what those same markets would be like without price limits. The

Chinese markets, having had periods with and without price limits, therefore provide a

unique setting to assess price limit effectiveness.

Our study of China’s experience with daily price limits yields many previously

unreported findings. Our major findings are twofold. First, when we contrast a subperiod

with price limits (i.e., the PL regime) to a subperiod without price limits (the no‐PL

regime), we find that equilibrium price discovery occurs faster after a stock hits its upper

price limit during the PL regime compared to stocks that do not hit price limits but would

have hit upper price limits had they been imposed during the no‐PL regime. Second, we

find that volatility and trading activities revert to normal faster after stocks hit price limits

during the PL regime compared to stocks that would have hit price limits during the no‐PL

regime. These findings are in contrast to prior price limit studies that argue price limits

delay price discovery, exacerbate volatility, and interfere with trading activities.

We also take advantage of another unique feature of China’s price limit

regulations to study price limit effectiveness. The stock exchange gives firms suffering

from poor performance a special treatment (ST) designation and imposes tighter price

limits: daily price limits on ST stocks are 5% instead of 10%. We find evidence that these

tighter price limits for ST stocks can be helpful. Specifically, when ST stocks hit upper

price limits, their volatility reverts to normal relatively quickly.

Finally, we test two additional hypotheses related to price limits and report

additional findings that reflect favorably on them. First, we conduct a simple test to determine

whether price limits are magnets (i.e., prices are drawn to limit prices). The magnet

494 The Journal of Financial Research