Most stock exchanges around the world impose daily price limits. For example, on any given trading day on the Chinese stock exchanges a stock price cannot change by more than 10 percent from its previous day’s closing price. The rationale behind price limits varies. They are believed to moderate excessive volatility, mitigate panic behavior, and/or minimize price manipulation (e.g., see Kim and Rhee (1997), Kim (2001), Kim and Yang (2004), and Kim and Park (2010)). However, for more than a decade, researchers have criticized price limits. According to many studies, price limits impede market efficiency, while showing no evidence of achieving their intended objectives. In this paper, we offer compelling and convincing evidence that shows benefits of price limits.
During 1992-1996, the Chinese stock markets did not use daily price limits (we refer to this period as the “no-PL-regime”). Other than this period, the Chinese markets have always imposed price limits. China is the only stock market in the world that has experienced trading with and without price limits. China’s experience with price limits is extremely useful and fortuitous from a research standpoint. A major shortcoming of all existing price limit studies is they inherently study markets with price limits, but in doing so they cannot possibly ascertain if those markets would be better off without price limits. The Chinese markets, having had periods with and without price limits, provides a unique laboratory setting to assess price limit effectiveness.
Our study of China’s experience with daily price limits yields three major sets of empirical findings. First, when we contrast a sub-period with price limits (i.e., the “PL-regime” sub-period) to a sub-period without price limits (the no-PL-regime), we find when stocks hit price limits during the PL-regime their volatility and trading activities return to “normal” faster compared to stocks that do not hit price limits but would have hit price limits had they been imposed during the no-PL-regime. These findings are in sharp contrast to prior price limit studies that argue price limits exacerbate volatility and delay trading activities. If firms are concerned about their stock price volatility and abnormal trading behavior, then our findings imply firms are better off when their stock prices are subject to daily price limits.
We also take advantage of another unique feature of China’s price limit regulations to study price limit effectiveness. For firms suffering from poor performance, the stock exchange gives them a Special Treatment (ST) designation and imposes tighter price limits daily price limits on ST stocks are 5% instead of 10%. We find evidence these tighter price limits for ST stocks are helpful (i.e., when ST stocks hit upper price limits, their volatility returns to “normal” relatively quickly) and not hurtful (i.e., when ST stocks hit lower price limits, they do not behave much differently compared to non-ST stocks that hit lower price limits).
