Causes of changing financial market volatility

Abstract

Financial market prices, prices of stocks, bonds, foreign exchange, and other investment assets, have shown striking changes in volatility through time. For each of these kinds of assets there are years when prices show enormous unpredictable movements from day to day or month to month, and there are years of stable, uneventful markets. Why does volatility change from year to year, and what (if anything) should be done about it by government regulators and self-regulatory organizations? The striking increase in stock market volatility since around the time of the stock market crash, October 19, 1987, makes these questions seem especially relevant now. Many people in the investing public are upset about the increased volatility, and are writing letters to congressmen, agency heads, and industry leaders to do something. The problem for those who formulate policy is that very little is known about the causes of changes in volatility of financial prices. This paper tries'to state what we know concretely about causes of changes in financial market volatility, discusses some of my own research on causes of the stock market crash of 1987, and presents a view of volatility in financial markets that is relevant to policy deci-sions to deal with the volatility. Changes in volatility through time The stock market The current episode of stock market volatility is hardly unique. 2 Robert J. Shiller There have been repeated episodes of high stock market volatility throughout stock market history. The stock market drop on October 19, 1987 was the biggest one-day price change ever in percentage terms. The Dow Jones Industrial Average fell 22.6 percent in one day. The drop was almost twice as big as the next biggest one-day drop, on October 28, 1929. However, the overall pattern of volatility in 1987 and 1988 is not so unique in history.' Chart 1 shows the changing volatility of stock prices, as measured by the standard deviation of percentage changes in the nominai Stan-

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