Chapter 20Volatility

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.