Slide 1 ©R. Schwartz Volatility: Markets at Risk

Bob SchwartzBob SchwartzZicklin School of BusinessZicklin School of BusinessBaruch College, CUNYBaruch College, CUNY

WFE Workshop on Market Structure & Statistics

Paris, December 1-2

Slide 2 ©R. Schwartz Volatility: Markets at Risk

Volatility and Risk

• Central importance in Finance

• Risk has a well defined meaning

• Risk is not the only contributor to volatility

Slide 3 ©R. Schwartz Volatility: Markets at Risk

Uncertainty

• We do not know the probability distribution

• We might not even know all of the outcomes

• Uncertainty is a major contributor to volatility

• We have not paid sufficient attention to uncertainty as a cause of volatility

Slide 4 ©R. Schwartz Volatility: Markets at Risk

A Little Red or Black Animal That Can Crawl Around and Annoy Us

Individually so dumb, collectively very smart

An Ant

Slide 5 ©R. Schwartz Volatility: Markets at Risk

Security Traders

Individually very smart, collectively so dumb

Slide 6 ©R. Schwartz Volatility: Markets at Risk

Why So Dumb?

• There is a great deal about volatility that we do not understand

• There is quite a bit that we thinkthink we understand but don’t!

That’s dangerous!

Slide 7 ©R. Schwartz Volatility: Markets at Risk

High Intra-day Volatility

• Really high volatility has been with us for over a year

• I do not mean long-run vol (weeks, months, or years) but…

• Intra-day vol!

• Price changes of 1%, 2% or more are common

• A 1% daily price change 250% annual change!

• What does intra-day volatility look like?

Slide 8 ©R. Schwartz Volatility: Markets at Risk

INTRA-DAY VOLATILITYNYSE

October - December 1999

0.00%

0.40%

0.80%

1.20%

1.60%

Hal

f-Hou

r V

olat

ility

The First 1/2 Hour

Slide 9 ©R. Schwartz Volatility: Markets at Risk

INTRADAY VOLATILITYNASDAQ

October - December 2000

0.00%

0.50%

1.00%

1.50%

2.00%

Ha

lf-H

ou

r V

ola

tili

ty

The First 1/2 Hour

Slide 10 ©R. Schwartz Volatility: Markets at Risk

January - May 2000

0

0.5

1

1.5

2

2.5

3

8:00-8:30

8:30-9:00

9:00-9:30

9:30-10:00

10:00-10:30

10:30-11:00

11:00-11:30

11:30-12:00

12:00-12:30

12:30-1:00

1:00-1:30

1:30-2:00

2:00-2:30

20:30-3:00

3:00-3:30

3:30-4:00

4:00-4:30

Ha

lf-H

ou

r V

ola

tili

ty

INTRADAY VOLATILITYLONDON STOCK EXCHANGE

The First 1/2 Hour

Slide 11 ©R. Schwartz Volatility: Markets at Risk

INTRADAY VOLATILITYEURONEXT PARIS

January - May 2000

0

0.2

0.4

0.6

0.8

1

1.2

1.4

9:00-9

:30

9:30-1

0:00

10:00

-10:30

10:30

-11:00

11:00

-11:30

11:30

-12:00

12:00

-12:30

12:30

-1:00

1:00-1

:30

1:30-2

:00

2:00-2

:30

2:30-3

:00

3:00-3

:30

3:30-4

:00

4:00-4

:30

4:30-5

:00

Clos

ing Call

Ha

lf-H

ou

r V

ola

tili

ty

The First 1/2 Hour

Slide 12 ©R. Schwartz Volatility: Markets at Risk

INTRADAY VOLATILITYDEUTSCHE BÖRSE

January - May 2000

0

0.2

0.4

0.6

0.8

1

1.2

Ha

lf-H

ou

r V

ola

tili

ty

The First 1/2 Hour

Slide 13 ©R. Schwartz Volatility: Markets at Risk

My Current Nasdaq Study

• 52 large cap Nasdaq firms

• Time period: Feb 04 and Feb 05

• We examined per day:

390 1-minute intervals (9:30-16:00)

30 10-second opening intervals (9:30-9:35)

30 10-second closing intervals (15:55-16:00)

• Volatility measured by high-low range for the interval

““The Quality of Price formation at Market Openings & Closings:The Quality of Price formation at Market Openings & Closings:Evidence from the Nasdaq Stock Market”Evidence from the Nasdaq Stock Market”

Michael Pagano, Lin Peng, and Robert SchwartzMichael Pagano, Lin Peng, and Robert Schwartz

Slide 14 ©R. Schwartz Volatility: Markets at Risk

Nasdaq Volatility Differences Between Feb 2004 and Feb 2005

One-minute Volatility

wr ange

0

20

40

60

i nt er val

0 30 60 90 120 150 180 210 240 270 300 330 360 390

60 bps60 bps Feb 2004 (Pre-Calls) Feb 2004 (Pre-Calls)r ange

0

20

40

60

i nt er val

0 30 60 90 120 150 180 210 240 270 300 330 360 390

60 bps60 bps Feb 2005 (Post-Calls) Feb 2005 (Post-Calls)

Slide 15 ©R. Schwartz Volatility: Markets at Risk

r ange

0

10

20

30

40

i nt er val

0 6 12 18 24 30 36 42 48 54 60

Nasdaq Volatility DifferencesBetween Feb 2004 And Feb 2005

10-Second Volatility

r ange

0

10

20

30

40

i nt er val

0 6 12 18 24 30 36 42 48 54 60

40 bps40 bps Feb 2004 (Pre-Calls) Feb 2004 (Pre-Calls)5 Min After

Opening5 Min Before

Close

40 bps40 bps Feb 2005 (Post-Calls) Feb 2005 (Post-Calls)5 Min After

Opening5 Min Before

Close

Slide 16 ©R. Schwartz Volatility: Markets at Risk

What Explains Accentuated Vol?

• Reason One: Price discovery

• Reason Two: Liquidity creation doesn’t just happen

• Volatility in opening minutes: Price discovery

• Volatility in closing minutes: End of day effects

• Volatility at any time of the day: One-sided markets

Slide 17 ©R. Schwartz Volatility: Markets at Risk

Reason One: Price Discovery

• A difficult process

• Especially complex when some investors are influenced by what they see other investors doing…

• That is when we get information cascades

Slide 18 ©R. Schwartz Volatility: Markets at Risk

Reason Two: Liquidity Creation

• Markets are generally two-sided under a spectrum of conditions

• But sometimes they are one-sided….

• Liquidity dries up on one side of the market and volatility spikes…

• Information cascades…

• And, when prices head south, who wants to catch the falling knife?

Slide 19 ©R. Schwartz Volatility: Markets at Risk

What To Do About It?1. Market Structure

• Transparency vs. opacity

• Consolidation vs. fragmentation

• Temporal consolidation and call auctions

• Circuit breakers and volatility interruptions

• Stabilization programs

Slide 20 ©R. Schwartz Volatility: Markets at Risk

Corporate Stabilization Programs

• A corporation can set up a STABILIZATION FUND

• Doing so is VOLUNTARY

• The fund is RUN BY A FIDUCIARY

• Shares and capital are put into the fund

• Shares are purchased in a falling market but…

• Shares are also sold in a rising market

• All orders are entered at pre-announced price points in pre-announced sizes according to an algo formula that is common knowledge

• Orders are executed in call auction trading only

• I proposed this in Fall 1988. I still believe in it.

Slide 21 ©R. Schwartz Volatility: Markets at Risk

• We have been hit by tidal waves of volatility

• Regulation is indeed needed

• But it must be appropriate

• Will it be?

• One thing is for sure…

What To Do About It?2. Regulatory Structure

Slide 22 ©R. Schwartz Volatility: Markets at Risk

The financial turbulence of 2008 has given us all a great deal to think about!