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February 16, 2009

Taming the Markets

Enhanced liquidity would dampen extreme volatility

By Robert A. Schwartz

Volatility and risk are of central importance to those of us involved in finance. But there is a great deal about them that we do not understand. Even more critically, there is quite a bit about volatility and risk that we think we understand but do not. I believe we have lost sight of the fact that risk is not the only contributor to volatility.

Risk has a well-defined meaning to economists: It exists when an outcome can be described as a draw from a probability distribution with known parameters. But along with risk, there is also uncertainty. With uncertainty, we do not know the probability distribution. We might not even know what all of the outcomes are. Dealing wisely with uncertainty is a huge challenge. In my opinion, we have not paid sufficient formal attention to uncertainty as a cause of volatility.

High volatility has been with us for more than a year now. I am not referring to price fluctuations over lengthy, multiyear periods. I am thinking of the very appreciable volatility that we experience, day after day, on an intraday basis. Price changes of 1 percent, 2 percent or more are common. A 1 percent daily price move, annualized, translates into a 250 percent change. We do not see annual swings of this magnitude very often. In the opening and closing minutes of trading, intraday price movements are even more accentuated. Why?

Reason number one has to do with price discovery. Share values are not found in the offices of the stock analysts, but are discovered in the marketplace. Share prices do not follow random walks, and they are not simply and uniquely linked to "the fundamentals." How can they be when, in the face of enormously complex and imprecise information, investors form diverse expectations of future corporate performance and thus, at any current moment, evaluate shares differently?

Good price discovery is very difficult to achieve, especially when some investors are influenced by what they see other investors doing. That is when we get information cascades and herding, that is when a market can get into trouble, and that is when inaccurate price discovery can contribute mightily to volatility.

Reason number two has to do with liquidity creation. In research done jointly with Asani Sarkar of the Federal Reserve Bank of New York, we have found that markets are generally two-sided, and that two-sidedness holds under a wide range of conditions. Sidedness refers to the extent to which buyers and sellers are both actively present in a market, in roughly equal proportions, in brief periods of time (e.g., five-minute intervals). Asani and I have found that two-sidedness holds for both Nasdaq and NYSE stocks; at market openings, midday and at the close; on days with news and on days when there is no major news; and for both large orders and small orders.

But markets are not always two-sided. At times, liquidity dries up on one side of the market, and volatility spikes. Information cascades can take over, and a market can become one-sided. And when prices suddenly head south, one-sidedness is accentuated as buyers simply stand aside.