The Threshold Effect in Expected Volatility: A Model Based on Asymmetric Information

Francois M Longin

Review of Financial Studies, 1997, vol. 10, issue 3, pages 837-69

Abstract: This article develops theoretical insight into the threshold effect in expected volatility, which means that large shocks are less persistent in volatility than small shocks. The model uses the Kyle-Admati-Pfleiderer setup with liquidity traders, informed traders, and a market maker. Information is modeled as a GARCH process. It is shown that the GARCH process for information is transformed into a TARCH process (for "threshold GARCH") for the market price changes. Working with information flows allows one to derive implications for trading volume and market liquidity which provide the basis for a more complete test of the model. Article published by Oxford University Press on behalf of the Society for Financial Studies in its journal, The Review of Financial Studies.

Date: 1997
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