Chapter 20 Volatility

Volatility  Fundamental volatility is due to unanticipated changes in instrument values Price changes due to adverse selection spread component contribute to fundamental volatility  Transitory volatility is due to trading activity by uninformed traders

Fundamental volatility factors Unexpected changes in  Interest rates and credit rating (bonds)  Factors that affect firm value (stocks)  National inflation rates, macroeconomic policies, and trade and capital flows (currencies)  Cash market supply and demand (commodities)

Other factors that affect fundamental volatility  Storage costs High storage costs → small inventories → demand shocks → high price volatility  Perishable goods  Fundamental uncertainties High PE ratios, high political risks, highly leveraged firms

Transitory volatility  Arises when the demands of impatient uninformed traders cause prices to diverge from fundamental values.  These price changes are transitory because prices eventually revert to fundamental values.  The transaction cost component of the bid-ask spread contributes to transitory volatility (i.e., bid-ask bounce).  Bid-ask bounce causes negative serial correlation in transaction price changes. See Roll’s model.