Work

Price dynamics with circuit breakers

Year: 2024

Type: article

Abstract: We model the dynamics of an asset price in the presence of a circuit breaker. A circuit breaker is a trading halt imposed by the exchange after the price drops below (or rises above) a pre-specified value within a trading session. The investors' anticipation of the probability of a halt feedbacks on the price process. This leads to coupled integral and stochastic differential equations. With first-order analytical solutions and numerical treatment, the theory predicts an increased price volatility prior to the trigger point, as has been reported in the empirical literature. We show that the sole existence of a circuit breaker leads to the negative effect of attracting the price to the circuit breaker level (known as the ``magnet effect''). We then propose first steps towards a more robust design of circuit breakers. In particular, we show that a trading halt that is conditioned on a pre-specified volatility level, instead of price level, mitigates the negative side effects of increased volatility. The methodology proposed in this article serves as starting point for the design of more resilient circuit breaker mechanisms.

Source: Quantitative Finance

DOI: 10.1080/14697688.2024.2429421

Authors: Sandro Claudio Lera, Didier Sornette, Florian Ulmann

Institutions: Southern University of Science and Technology, Massachusetts Institute of Technology, ETH Zurich

Language: English

Topic: Stochastic processes and financial applications

Subfield: Finance

Field: Economics, Econometrics and Finance

Domain: Social Sciences

Open Access status: green

Funders: Schweizerischer Nationalfonds zur Förderung der Wissenschaftlichen Forschung, National Natural Science Foundation of China, Southern University of Science and Technology

Awards: G6033198055, G6537101675