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Stabilizing effect of volatility in financial markets
Davide Valenti1,2, Giorgio Fazio3,4, Bernardo Spagnolo1,5,6
1Dipartimento di Fisica e Chimica, Group of Interdisciplinary Theoretical Physics and CNISM, Università di Palermo, Viale delle Scienze, Edificio 18, I-90128 Palermo, Italy.
Physical Review. E
|July 18, 2018
Summary
Financial markets exhibit instability even during low volatility periods. This study introduces mean first hitting time as a novel stability indicator, revealing that both low and high volatility can signal market risk.
Area of Science:
- Quantitative Finance
- Financial Market Analysis
- Risk Management
Background:
- Conventional financial market wisdom equates higher volatility with greater risk.
- Periods of low price fluctuation can precede significant market downturns (crashes) or upturns (rallies).
- This counterintuitive phenomenon requires a more nuanced understanding of market stability.
Purpose of the Study:
- To propose and validate the mean first hitting time (MFHT) as a novel indicator of financial market stability.
- To investigate the relationship between MFHT and standard volatility measures.
- To challenge the conventional view that only high volatility signifies market instability.
Main Methods:
- Calculated the mean first hitting time (MFHT) for large positive (rallies) and negative (crashes) stock return variations.
- Empirically analyzed daily stock returns for 1071 New York Stock Exchange-traded stocks.
- Utilized a nonlinear Heston model to reproduce statistical properties of the empirical data.
Main Results:
- The MFHT, as a measure of price stability, exhibited non-monotonic behavior as a function of volatility, showing a maximum.
- Empirical data demonstrated that both low and high volatility periods can be associated with increased market instability.
- The nonlinear Heston model successfully replicated the observed statistical properties of stock returns.
Conclusions:
- Contrary to traditional assumptions, low volatility does not always equate to market stability.
- The MFHT offers a valuable new metric for assessing financial market risk and instability.
- This finding has significant implications for risk control strategies in financial markets.
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