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Stock price volatility

Introduction

Stock price volatility is actively studied topic in today’s world. As we all know about stock prices but what volatility is? Volatility is a measure for variation of price of a financial instrument over time and Stock price volatility is an indicator that is most often used by options traders to find changes in trends in the market place. Volatility comprises of two types. Historic volatility which is derived from time series of past market prices and implied volatility which is derived from the market price of a market traded derivative (in particular an option).

The increase or decrease in volatility results from changes in investors emotions in the market place. More specifically greed and fear in the market place are the two main factors that cause stock prices to change. Stock price volatility tends to rise when there is new information released in the markets however the extent to which it rises is determined by the relevance of that new information as well as to the degree in which the news surprises investors. In report we will discuss both types of volatility and how each type is used.

Historical volatility, often referred to as actual volatility and realized volatility, is the measure

of a stock’s price movement based on historical prices (stock price history) and it is used to measure how active a stock price typically is over time. It measures the fluctuations in the share price, and more specifically it is measured by taking the daily percentage price changes in a stock and calculating the average over a specific time frame.

Implied volatility is the current volatility of a stock and is estimated by its option price. In other

words, the implied stock price volatility is that level of volatility that will calculate a fair value that is equal to the current trading option price. When looking at an option to determine its implied volatility, there are five parts to take into account. These include the strike price, the expiration date, the current stock price and the stock dividends paid by the stock. Investors will then use an options pricing model.

Evolution

Stock markets did not begin as the super-sophisticated, simultaneous, worldwide trading exchanges of today. It was not until 1531 when the first institution roughly approximating a stock market emerged, in Antwerp, Belgium. However, according to investopedia data, this was, “…the first stock market, sans stock.” Rather than buying and selling shares of companies (which did not yet exist), brokers and lenders congregated there to “deal in business, government and even individual debt issues.”

This changed in the 1600′s, when Britain, France, and the Netherlands all chartered voyages to the East Indies. Realizing that few explorers could afford conducting an overseas trade voyage, limited liability companies were formed to raise money from investors, who received a share of profits commensurate with their investment.

This form of business organization was also necessitated by risk management. As India’s Imperial Gazetteer reports, the earliest British voyages to the Indian Ocean were unsuccessful,

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resulting in lost ships and the financier’s personal fortunes being seized by creditors. This led a group of London merchants to form a corporation in September of 1599 which would limit each member’s liability to the amount they personally invested. If the voyage failed, nothing more than this amount could be lawfully seized. The Queen granted the merchants a fifteen year charter in 1600, dubbing their corporation the “Governor and Company of Merchants of London trading with the East Indies” (or simply, “The East India Company.”) The limited liability formula proved successful, leading King James I to grant charters to more trading companies by 1609 and triggering business growth in other ocean-bordering European countries.

The Dutch East India Company was actually the first to allow outside investors to purchase shares entitling them to a fixed percentage of the company’s profits. They were also the first company to issue stocks and bonds to the general public, doing so via the Amsterdam Stock Exchange in 1602 according to Britannica.

Stock exchanges grew more prominent in the 18th and 19th centuries as a result of the increase in wealth generated by industrialization in Europe and America. The New York Stock Exchange, currently the biggest stock exchange in the world, became the center of, first American, and then the world's financial system.

Liberalization of the financial industry in the 1980s and the Internet Revolution of the 1990s made global electronic transactions possible, greatly increasing stock market value and liquidity. Today, stock exchanges are an extremely important market institution and the lifeblood of a globalized financial system.

Arguments from cited articles

In this section we will see the role of different variables in determining the volatility in the stock prices in Pakistan and the determinants involved in that procedure are corporate dividend policy, exchange rate variation, retained earning level and impact of short interest on stock market prices. And at last we will see the impact of stock price volatility on the economy of Pakistan.

 Effects of corporate dividend policy:

Different authors have different viewpoints about dividend policy and stock price volatility. Modigilani and Miller say that stock price volatility is totally based on firm’s earning ability and not on the dividend policy. John and William says above information is only true when shareholders have symmetric information about company. Number of authors proves the positive relation between stock price volatility and dividend policy. Managers mostly tend to invest in negative NPV projects to maximize their own utility and in return cause the value of the firm to decrease due to over investments. So, company will have less idle resources for investing in negative NPV projects after distributing cash dividends. It means if firm distribute less dividends then devaluation in stocks might occur but we should remember that a firm with better growth opportunities might use these idle funds efficiently. Results of this article also supported the positive relation between both variables after testing the sample of 73 people from KESC.

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 Effects of Exchange rate variation:

A change in exchange rate has two effects on stock prices:  a direct effect through multinational firms

 indirect effect through domestic firms

For a multinational firm involved in exports, a change in exchange rate will change the demand of its product in the international market. The same ultimately reflects in its balance sheet as profit or loss. Once the profit or loss is declared, its stock prices will also change for a domestic firm. On the other hand, currency devaluation could either raise or decrease a firm's stock price. This depends on the firm nature of operations. A domestic firm that exports part of its output will benefit directly from devaluation due to an increase in demand for its output. As higher sales result in higher profits, local currency devaluation will cause firm stock price to rise in general. However, if the firm uses imported inputs, currency devaluation will raise the costs and lower profits, thus creating a decline in firm's stock price.

Empirical studies provide contradictory results towards the relationship between exchange rate and stock prices for both fixed exchange rate and flexible exchange rate system. For Example, studies indicated a negative relationship between stock prices and exchange rate. A positive relationship was indicated by Aggarwal (1981) and remaining studies found no relationship between stock prices and exchange rate. Most of these researchers tested the impact of exchange rate on stock prices. However, very few have investigated the causal relationship between exchange rate and stock prices. In Pakistan, because of poor saving rate, limited investment opportunities and lack of awareness, less than 1% of the Population participates in stock market transactions. However, like in many developing countries, investors in Pakistan diversify low portion of risk in different forms. When they make a portfolio decision investors in Pakistan put their money in different forms, namely cash, particularly the US dollar (56%), gold, estate properties, bonds and shares (12.25%), lending (they put the money in saving accounts, 30.75%) and the remaining investment, in insurance (1%)2. The dollar yields the largest return, which varies from 20% to 25% per year as compared to an average return of 10% on other investments. Average inflation rate in Pakistan has been between 6% and 10%. As a result, domestic currency depreciated by almost 50% during study period and hence increased the value and demand for alternative currency, the US dollar.

The volatility in exchange rate reached its peak in May 1998 after the nuclear test. Its consequence is a decrease in the value of Pakistani currency against the dollar. Its rate decrease from an average of Rs. 39 to Rs 50. Facing an acute foreign exchange crunch following the freeze of foreign currency accounts and international economic sanctions have brought many undesirable effects on Pakistan's economy. At the Karachi stock exchange the investor's confidence was badly shaken. During this period persistence in volatility in both stock price indices and exchange rate were observed.

The results indicate that the stock price has negative significant short run causal effect on exchange rate in Pakistan. No significance relationship is found between stock prices and gold. It suggests that the stock market in Pakistan is inefficient with respect to gold prices. However,

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money supply and interest rate do affect stock prices, suggesting that monetary policy could be used more effectively to check the movement in stock prices in Pakistan.

Effect of retention in retained earnings on common stock prices:

It is assumed that there is a positive association between earnings retention and appreciation in the market price of common stock. But many additional factors are also needed to analyze. For example, if a firm's capital structure is top- heavy, like railroads, the retention of earnings available for the common stock will serve more to increase the assets protecting the bondholders than to improve the future dividend expectations of the stockholders, and should have little effect on price. Or, in the case of a declining firm, the retention of earnings may only serve to reduce the rate at which the stock declines in price. On other hand there are two propositions about the situation. One proposition states that, given two stocks similar in all respects but dividend payout, a higher price will be paid for the stock of the company distributing a greater proportion of its earnings in dividends. The emphasis of this proposition is on the immediate reward to the investor for the use of his funds. The other proposition states that those firms which are growing rapidly generally retain a substantial part of their profits to finance their expansion. Therefore, a higher proportion of earnings retained is associated with greater price appreciation. The crucial factor is the profitable utilization of investors' funds. The studies of the individual companies demonstrate that the mere fact of low dividend payout does not guarantee outstanding price appreciation. Increases in earning power must increases in book value arising from undistributed profits.

 Impact of Short Interest on Stock Market Prices:

In this article the author (Randall D. Smith) describe that the effect of short interest on stock market prices in investment community. An investor borrows stock and sells it to others. Later on he (Randall D. Smith) repurchased stock in order to return the borrowed stock. This process is called short sale. The author tried to explain that either his purchase will exert an upward or downward impact on stock price. Author says that short interest is considered to be an important by many observers and can simply be expressed as the number of shares sold short but not yet covered or closed out. Short interest data is widely and easily available online. This study explains the empirical relationship between short interest and market price by using two different methods, one is statistical and the other is simulation techniques. In this article American stock exchange companies are chosen but not New York stock exchange because American stock exchanges companies have fewer shares outstanding and trade less actively. So the effect of short interest on these companies will also be greater as compared to New York stock exchange companies which are less volatile and have deeper market. Tests were performed on basic sample of stock as well as many variations basic sample. High and rising short interest is said to be bullish for the stock. In basic sample high short interest is defined as 20,000 or more and rising short interest can be defined as an increase of 3000 shares from previous month. The sample was tested during from Oct. 1967 to June 1968. This duration had

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chosen because stock market faces equal no. of monthly advances and declines during this period.

The price change was measured which is associated with the short interest for each month. The author explains the determinants of price change were the opening (the day after the announcement) and closing on (the day of the announcement one month later). Speculator could only take benefit of the short interest information from the beginning of this period. At ending date speculator will consider the information in the new announcement of short interest.

The result shows that price changes for the basic sample are in the same direction as of American stock exchanges companies, but greater in magnitude. High short interest does not have an upward price impact on stock. Buying stock with high position does not improve on random selection of stock. Stocks having high short position only have one different characteristic that is greater volatility. High short positions can be used to select unusually risky stocks, if price volatility is considered to be measure of risk. Risk-averting investor will prefer to avoid from this risk, because there is no compensation for bearing this risk. However, if investor has strong information related to increase in price then short interest will provide a means of contributing in the rise. On the other hand if it is expected that there will be large decline in prices, it is better to sell stocks on short position.

Impact of stock price volatility on the economy of Pakistan

:

Stock market as the leading indicator of the economic activity in the country

 Impact of stock market on aggregate demand particularly through aggregate consumption and investment

Stock market reflects investors attempt to forecast economic trends. It is evident that the stock market and economic activity do move in similar cyclical pattern. Stock market has important links to aggregate economic activity in Pakistan through the two components of aggregate demand like consumption expenditure and investment. There is investigation of the links that exist between changes in the stock market and the aggregate economic activity.

The relationship between the change in stock price and the level of real household consumption expenditure is basically based on life cycle theory .The households project their wealth or resource over their expected lifetime and consumption plan decisions are taken according to their best preferences. Stocks are one of the alternatives in which the households can invest their wealth. The increase in the share price means capital gain and hence increases in wealth, which in fact provides additional consumption expenditure. The stock market and investment behavior are bound together since firms invest to earn profits, and all activities in the stock market represent the investment effect to evaluate the magnitude of their stream profits. It is hypothesized that fluctuations in stock prices affect the amount of investment spending of firms. The changes in stock prices have direct relationship with investment expenditure. It is in the best interest of the shareholders if the firms buy new equipments or

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structure when the market value of the firm is expected to rise by more than the cost of additional physical capital. This is the case when the share prices are high. If the share prices are low, the strategy for a firm would be to buy an existing firms’ outstanding stock, rather than buying new capital.

The other approach is developed by the neoclassical model or cost of capital model which gives the less direct link from stock price to investment expenditure. In this model it is assumed that firms first determine the stock of real capital they desired based on the price of labor, capital and expected sales. Then the rate of investment is determined by the firms, depending how fast they wish to reach the desired capital stock in the face of significant adjustment cost. The same indicates that expected fluctuations in sales and planned output are the major determinants of investment. However, in this respect, it is argued that higher expected output implies higher earnings, which in turn increase stock prices and then the securities valuation model implicitly accounts for the effect of expected output.

The stock market in any country is viewed as a leading indicator of economic activity. The changes in stock prices are hypothesized to temporally lead changes in economic activity over time. To establish the relationship between stock market and economic activity in Pakistan, we consider two measures of economic activity i.e. real Gross Domestic Product, and index of industrial production. The industrial production in considered to be a close proxy for economic activity since most of the firms listed with stock exchange are engaged in industrial production and for country like Pakistan the turning point in industrial production matches with the turning point in overall economic activity.

This attempt is taken to determine important link between stock market and aggregate economic activity in Pakistan. The results suggest the direction of relationship from stock prices changes to consumption expenditure which supports the existence of wealth effect. It is interesting to note that though the stock holding out of total wealth is small, there is observed a wealth effect in Pakistan economy. The reason may be that there are few alternatives for profitable investment for Pakistani households for their intertemporal decision and more relief in investment. The causality relationship is established from investment to stock market supports the neoclassical model of cost of capital, which suggest that the Pakistani firms first determine the stock of real capital they desire and then determine the rate of investment. The result showing a weak relationship between economic activity (GDP) and stock prices, suggests that GDP temporarily leads stock prices. In Pakistan stock market reacts to change in industrial production. The reason is that the firms listed on stock market are mainly earning for industrial sector. This feedback relationship suggests that stock market in Pakistan appears to be informational efficient with respect to real activity. This study clearly concludes that stock market in Pakistan is fully capable of channeling the funds for most productive sectors of the economy.

 Stock price volatility, further development:

Efficient capital markets theory implies that stock prices should be much less volatile than actually observed, reflecting an unrealistic assumption that investors are risk neutral. If instead investors are assumed to be risk averse, predicted volatility is higher. However, models that

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incorporate investor avoidance of risk can explain real-world stock price volatility only under levels of risk aversion that are unrealistically high. Thus, price volatility remains unexplained. The defining claim of efficient capital markets theory was that, if investors process information efficiently and price stocks rationally, then future returns cannot be forecast. That’s because, if returns could reliably be forecast to be abnormally high in the future, investors would buy stocks now. That would cause stock prices to rise immediately, bringing future returns down to a normal level. The reverse would take place if returns could be forecast to be abnormally low. Empirical research appeared to confirm that financial market returns can’t be forecast. In an efficient market, stock prices should be considerably less volatile than they actually are in the real world. The inability of efficient markets theory to explain price volatility stems at least partly from the fact that it doesn’t take into account investor risk aversion. Recent research has moved away from the efficient capital markets assumption of risk neutrality, postulating instead that investors are averse to risk.

Early stock market gurus such as Benjamin Graham and David Dodd (1940) held that stocks should be traded based on the relationship between their prices and the discounted value of their expected future dividends. This present value model assumed that the discount rate could be held constant. At first glance, the efficient markets model appeared to conflict with this present value model. However, Samuelson (1965) showed that, far from being contradictory, the present value and efficient markets models were essentially equivalent. If stock prices equal expected future dividends discounted at a constant rate, returns in fact can’t be forecast. Further, the assumption that stock prices equal expected future dividends independent of the volatility of dividends can be justified only if investor risk aversion is excluded. If investors are risk averse, stock prices will depend on how variable dividends are as well as on their expected levels. By ignoring this effect, market efficiency implicitly treats investors as being risk neutral. In a theoretical model, Lansing and LeRoy (2011) computed the stock price volatility implied by different levels of risk aversion. Like Shiller, they found that, under risk neutrality, predicted maximum stock price volatility is much lower than what is actually seen in the market. They also found that the higher the level of risk aversion, the higher the maximum stock price volatility. To generate a price volatility level near that seen in the real world, the model needs an implausibly high level of risk aversion around 4 or 5, implying a probability of success around 0.94 in the gamble described above. Most investors would not need such a high probability of success to accept the risk.

What’s more, risk aversion must be even higher if the stock price volatility implied by formal models is to be reconciled with actually observed volatility. Maximum volatility in the models is based on the implausible presumption that investors can predict dividends with perfect accuracy into the indefinite future. If investor ability to predict future dividends is more limited, then predicted price volatility will be lower under a given degree of risk aversion. Accordingly, still-higher levels of risk aversion are required to account for real-world price volatility.

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To summarize, allowing for risk aversion can in principle generate stock price volatility similar to that seen in real-world financial markets. However, that assumes either that investors are implausibly risk averse or that they can predict dividends into the distant future, or both. Otherwise, price volatility surpasses levels that can be explained by fundamentals. It follows that assuming that investors have reasonable levels of risk aversion is not enough to explain why stock prices are so volatile.

Conclusion:

This report elaborates the stock prices and the relation of stock prices with different factors like dividend policy, exchange rates, retained earning level, the impact of stock price volatility on economic activities of the country and the impact of short interest on stock market prices. The stock price volatility in increasing or decreasing order put effect on Investment relatively. Investors measure the historical volatility and implied volatility for investment decisions.

Exchange rate affects the stock prices in different direction. It depends upon the nature of operations of the entity like in a multinational organization stock prices has direct relationship with the exchange rate and in domestic companies stock prices has indirect relationship with the exchange rate. There are two propositions of dividend distribution and retained earnings retention which affect the stock prices. First proposition states that, given two stocks similar in all respects but different dividend payout, a higher price will be paid for the stock of the company distributing a greater proportion of its earnings in dividends. The emphasis of this proposition is on the immediate reward to the investor for the use of his funds.

The other proposition states that those firms which are growing rapidly generally retain a substantial part of their profits to finance their expansion. Therefore, a higher proportion of earnings retained are associated with greater price appreciation. The important factor is the profitable utilization of investors' funds. The studies of the individual companies demonstrate that the fact of low dividend payout does not show outstanding price appreciation. Increases in earning power must increases in book value.

The stock with high and rising stock interest shows greater volatility than the selected random sample. Results from the New York stock exchange are generally same as of the American exchange stocks. Thus, short position in a stock does not have the effect attributed. It does not lead to towards the establishment of successful automatic trading rule, but only it provide information which may be useful for investor. Stocks which have high short position also have greater volatility which means that high short interest does not have upward impact on stocks market prices.

The stock market is used an important indicator to reflect economic activities in the country. If the stock prices are changed, the level of economic activities also changed. Two measures of economic activity i.e. real Gross Domestic Product, and index of industrial production are used to build a relationship between stock market and economic activity. Stock market put a great impact on aggregate demand particularly through aggregate consumption and investment.

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References

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