Mathematical Finance Seminar
RUD 25; 1.115
Hao Xing (Boston)

The Dark Side of Circuit Breakers

Market-wide trading halts, also called circuit breakers, have been widely adopted as part of the stock market architecture, in the hope of stabilizing the market during dramatic price declines.  We develop an intertemporal equilibrium model to examine how circuit breakers impact market behavior and welfare.  We show that a circuit breaker tends to lower the level of price and significantly alters its dynamics.  In particular, as the price approaches the circuit breaker, its volatility rises drastically, accelerating the chance of triggering the circuit breaker -- the so-called ``magnet effect''.  In addition, returns exhibit increasing negative skewness and positive drift, while trading activity spikes up.  Our empirical analysis finds supportive evidence for the model's predictions.  Moreover, we show that a circuit breaker can affect the overall welfare either negatively or positively, depending on the relative significance of investors' trading motives for risk sharing vs. irrational speculation. This is a joint work with Hui Chen, Anton Petukhov, and Jiang Wang.