1. ©R. Schwartz Volatility: Markets at Risk Slide 1 Bob Schwartz Zicklin School of Business Baruch College, CUNY WFE Workshop on Market Structure & Statistics Paris, December 1-2

2. ©R. Schwartz Volatility: Markets at Risk Slide 2 Volatility and Risk Central importance in Finance Risk has a well defined meaning Risk is not the only contributor to volatility

3. ©R. Schwartz Volatility: Markets at Risk Slide 3 Uncertainty We do not know the probability distribution We might not even know all of the outcomes Uncertainty is a major contributor to volatility We have not paid sufficient attention to uncertainty as a cause of volatility

4. ©R. Schwartz Volatility: Markets at Risk Slide 4 A Little Red or Black Animal That Can Crawl Around and Annoy Us Individually so dumb, collectively very smart An Ant

5. ©R. Schwartz Volatility: Markets at Risk Slide 5 Security Traders Individually very smart, collectively so dumb

6. ©R. Schwartz Volatility: Markets at Risk Slide 6 Why So Dumb? There is a great deal about volatility that we do not understand think There is quite a bit that we think we understand but don’t! That’s dangerous!

7. ©R. Schwartz Volatility: Markets at Risk Slide 7 High Intra-day Volatility Really high volatility has been with us for over a year I do not mean long-run vol (weeks, months, or years) but… Intra-day vol! Price changes of 1%, 2% or more are common A 1% daily price change  250% annual change! What does intra-day volatility look like?

8. ©R. Schwartz Volatility: Markets at Risk Slide 8 INTRA-DAY VOLATILITY NYSE The First 1/2 Hour

9. ©R. Schwartz Volatility: Markets at Risk Slide 9 INTRADAY VOLATILITY NASDAQ The First 1/2 Hour

10. ©R. Schwartz Volatility: Markets at Risk Slide 10 INTRADAY VOLATILITY LONDON STOCK EXCHANGE The First 1/2 Hour

11. ©R. Schwartz Volatility: Markets at Risk Slide 11 INTRADAY VOLATILITY EURONEXT PARIS The First 1/2 Hour

12. ©R. Schwartz Volatility: Markets at Risk Slide 12 INTRADAY VOLATILITY DEUTSCHE B Ö RSE The First 1/2 Hour

13. ©R. Schwartz Volatility: Markets at Risk Slide 13 My Current Nasdaq Study 52 large cap Nasdaq firms Time period: Feb 04 and Feb 05 We examined per day:  390 1-minute intervals (9:30-16:00)  30 10-second opening intervals (9:30-9:35)  30 10-second closing intervals (15:55-16:00) Volatility measured by high-low range for the interval “The Quality of Price formation at Market Openings & Closings: Evidence from the Nasdaq Stock Market” Michael Pagano, Lin Peng, and Robert Schwartz

14. ©R. Schwartz Volatility: Markets at Risk Slide 14 Nasdaq Volatility Differences Between Feb 2004 and Feb 2005 One-minute Volatility w 60 bps Feb 2004 (Pre-Calls) 60 bps Feb 2005 (Post-Calls)

15. ©R. Schwartz Volatility: Markets at Risk Slide 15 Nasdaq Volatility Differences Between Feb 2004 And Feb 2005 10-Second Volatility 40 bps Feb 2004 (Pre-Calls) 5 Min After Opening 5 Min Before Close 40 bps Feb 2005 (Post-Calls) 5 Min After Opening 5 Min Before Close

16. ©R. Schwartz Volatility: Markets at Risk Slide 16 What Explains Accentuated Vol? Reason One: Price discovery Reason Two: Liquidity creation doesn’t just happen Volatility in opening minutes: Price discovery Volatility in closing minutes: End of day effects Volatility at any time of the day: One-sided markets

17. ©R. Schwartz Volatility: Markets at Risk Slide 17 Reason One: Price Discovery A difficult process Especially complex when some investors are influenced by what they see other investors doing… That is when we get information cascades

18. ©R. Schwartz Volatility: Markets at Risk Slide 18 Reason Two: Liquidity Creation Markets are generally two-sided under a spectrum of conditions But sometimes they are one-sided…. Liquidity dries up on one side of the market and volatility spikes… Information cascades… And, when prices head south, who wants to catch the falling knife?

19. ©R. Schwartz Volatility: Markets at Risk Slide 19 What To Do About It? 1. Market Structure Transparency vs. opacity Consolidation vs. fragmentation Temporal consolidation and call auctions Circuit breakers and volatility interruptions Stabilization programs

20. ©R. Schwartz Volatility: Markets at Risk Slide 20 Corporate Stabilization Programs A corporation can set up a STABILIZATION FUND Doing so is VOLUNTARY The fund is RUN BY A FIDUCIARY Shares and capital are put into the fund Shares are purchased in a falling market but… Shares are also sold in a rising market All orders are entered at pre-announced price points in pre- announced sizes according to an algo formula that is common knowledge Orders are executed in call auction trading only I proposed this in Fall 1988. I still believe in it.

21. ©R. Schwartz Volatility: Markets at Risk Slide 21 We have been hit by tidal waves of volatility Regulation is indeed needed But it must be appropriate Will it be? One thing is for sure… What To Do About It? 2. Regulatory Structure

22. ©R. Schwartz Volatility: Markets at Risk Slide 22 The financial turbulence of 2008 has given us all a great deal to think about!