Chapter 20
Volatility
Volatility

Fundamental volatility is due to
unanticipated changes in instrument
values
•

Price changes due to adverse selection
spread component contribute to fundamental
volatility
Transitory volatility is due to trading activity
by uninformed traders
Fundamental volatility factors
Unexpected changes in
Interest rates and credit rating (bonds)
 Factors that affect firm value (stocks)
 National inflation rates, macroeconomic
policies, and trade and capital flows
(currencies)
 Cash market supply and demand
(commodities)

Other factors that affect
fundamental volatility
Storage costs
High storage costs → small inventories
→ demand shocks → high price volatility
 Perishable goods
 Fundamental uncertainties

•
High PE ratios, high political risks, highly
leveraged firms
Transitory volatility
Arises when the demands of impatient
uninformed traders cause prices to diverge
from fundamental values.
 These price changes are transitory because
prices eventually revert to fundamental values.
 The transaction cost component of the bid-ask
spread contributes to transitory volatility (i.e.,
bid-ask bounce).
 Bid-ask bounce causes negative serial
correlation in transaction price changes. See
Roll’s model.
