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Despite widely documented criticisms, price-limit rules are present in many equity markets around the world. Using a game-theoretic model, we argue that, if the cost of monitoring a market is high, price-limit rules are beneficial. Empirical tests based on a cross section of 43 equity markets across five continents support our theoretical prediction. We find that the probability of the existence of price-limit rules is greater in markets that incur higher monitoring costs due to poorer business disclosure, more corruption and less efficiency in legal, regulatory and technological environments.

In this paper, we provide a rationale for the popularity of price-limit rules in many equity markets around the world. We investigate the conditions that encourage stock exchange officials to consider rule-based price limits along with discretionary trading halts. We focus on the costs associated with completely replacing rule-based price limits with discretionary trading halts. We argue that, given the high expenses associated with continuous market monitoring, the use of rule-based price limits is determined by the level of maturity of a stock market and the systematic efficiencies in its legal and regulatory environment. In markets where monitoring costs are shared between the firms and the regulator, the use of price-limit rules will be much lower. For example, NASDAQ Stock Market Rules IM-4120-1, 4310(c)(15) and 4320(e)(13) require listed firms to provide full and prompt responses to NASDAQ requests for information related to unusual market activity or to events that may materially impact the trading of its securities. Likewise, the Australian Stock Exchange’s (ASX) Rule 3.1B obliges firms to monitor market trading continuously and to explain any abnormal trading activity questioned by the exchange. It should be noted that stock exchanges take several other monitoring and governance measures to enhance the effectiveness and the fairness of equity markets.1 We argue that the cost of market monitoring is high when a market has systematic inefficiencies, such as poor business disclosure or lack of infrastructure or legal support. This is consistent with the findings of Frost et al. (2006). Therefore, regulators and exchange officials in such markets are often less informed and less equipped to detect information asymmetry and market abuse. As a result, in these markets, discretionary measures such as trading halts are not only costly, but also inadequate to serve as an optimal price-stabilizing mechanism. There are several instances of equity exchanges and market regulators explicitly stating the use of daily price-limit rules as a means to curb market manipulations. The Philippine Stock Exchange mentions on its website that price limits are used to reduce market manipulation. The Securities Exchange Board of India is currently contemplating an introduction of price limits on the first day of re-listing of suspended stocks to control price manipulative activities.2 Our study makes two contributions to the literature. First, to the best of our knowledge, as one of the few studies to model the role of price-limit rules in the context of price manipulations, our paper is the first to explicitly incorporate market monitoring costs into the tradeoff analysis. Second, we support our theory with a comprehensive empirical analysis using price-limit rules data covering more than 80% of the world’s stock markets. Consistent with our theoretical predictions, we find that the probability of the existence of price-limit rules is higher in countries that face higher monitoring costs due to poorer business disclosure, higher corruption levels and lower efficiency in the legal, regulatory and technological environments. A recent paper by Kim and Park (2010) is closely related to this study, in that they also investigate the role of price-limit rules in the presence of price manipulators. Our paper differs from theirs in three important ways. First, the theoretical model of Kim and Park (2010) focuses on how price limits can reduce the profitability of price manipulation. In contrast, our model emphasizes the benefits of price limits to the market regulators and participants. Second, Kim and Park (2010) do not model the costs of market monitoring, which regulators must incur to be effective. Our model incorporates cost and efficiency of market monitoring and shows how these variables may influence the existence of price-limit rules. Third, Kim and Park (2010)’s model is silent about the negative impacts of price-limit rules on market quality. As empirical evidence suggests that price limits affect price discovery and liquidity, we include these costs in the regulator’s benefit function. Our model incorporates the possibility that price limits may decrease the profit potential of market manipulators and can make market monitoring more effective but, at the same time, may reduce the regulator’s benefits from an orderly market. In a market where monitoring is costly, our model characterizes the conditions under which the benefits of price limits exceed the costs. The rest of the paper is organized as follows. Section 2 provides the context of our paper in the price limits literature. Section 3 presents the theoretical model. Section 4 defines the econometric model and the data. Section 5 presents the empirical analysis. Section 6 concludes.

We provide an explanation why regulators of some equity markets use daily price-limit rules even though many theoretical and empirical studies criticize their usefulness. Using a game-theoretic framework, we analyze the interaction between a market regulator and price manipulators. Our model shows that, in a market prone to price manipulations and characterized by high monitoring costs, price-limit rules can actually increase monitoring efficiency and benefit regulators and traders alike. The empirical evidence supports our theoretical argument. Analyzing a sample of 43 countries across five continents, we find that the probability of imposing price-limit rules is greater in countries that incur higher monitoring costs due to poorer business disclosure, higher corruption level and lower efficiency in the legal, regulatory and technological environments.