Price Volatility and Market Frictions

How market frictions affect price volatility is an important issue in finance. In this paper we propose a derivation of the price volatility in the model of Bayesian updates. We link price volatility to the fundamental (asset) volatility and the participation rate of the informed trader and derive an equilibrium ratio of informed and uninformed traders. This ratio depends on frictions, such as tick size. Our model predicts that price volatility increases as tick size is reduced, and vice versa. Because the all-familiar tests of NYSE (2000) and NASDAQ (2001) decimalizations are inconclusive, we explore this hypothesis using the Russian Federation bond data surrounding the event of 1000-fold re-denomination of the ruble in 1998. Results show that volatility of bond yields declines sharply after the increase in the tick size. This finding strongly supports the contention that market frictions affect price volatility. Note: This paper is a new, significantly revised version of the Statistical Properties of an Informed Trading Model