Test of the overreaction theory of price limits in futures markets

TL;DRAbstract

In this thesis we examine the effects of daily price limits on futures trading and test the overreaction theory of price limits in futures markets. The overreaction theory states that price limits can be used to correct the overreaction in the market and then reduce the excess volatility. This thesis studies both corn and soybean futures on the Chicago Board of Trade during a twelve year period from July l, 1982, to November 30, 2004, and conducts tests to see if the futures price volatility is reduced during the day or days after limit hits in futures markets. We use event study methodology to compare matched samples. Our tests find little evidence supporting the overreaction theory. On the contrary, our results show strong spillover effects and provide strong evidence indicating that price limits mainly suspend the transaction and delay the price discovery and make the market less efficient, especially when the price limit level is set too narrow. Further tests indicate that the over

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