Abstract

The use of price limits to dampen investor's overreaction or speculation behavior is not uncommon in many financial markets. While some research shows that market volatility decreases after the price limits are triggered, others find just the opposite. To better measure the effect of price limits on investor behavior, this study examines the sensitivity of implied volatility in the market. Specifically, given that the implied volatility represents a consensus measure of future volatility in the market, the behavior of implied volatility around price limits change can serve as a good measure of investor's view about future volatility prospect. Using data from the domestic warrant market, our findings show that when the lower price limit becomes more restrictive, the implied volatility in the market decrease significantly and seem to exert cooling-off effect. However, for stocks that tend to hit the price limits more easily (stocks that are more volatile, more actively traded, and with smaller market capitalization), their implied volatilities actually increase when more restrictive price limits are imposed. This finding confirms the view of Fama (1989) that price limits delay the price discovery process in the market.