International Review of Financial Analysis 30 (2013) 141148

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International Review of Financial Analysis

Predicting the limit-hit frequency in futures contracts

Tamir Levy a, Mahmod Qadan b, Joseph Yagil c,
a b c

Netanya Academic College, Israel Western-Galilee Academic College, Israel Haifa University, Israel

a r t i c l e

i n f o

a b s t r a c t
This study demonstrates how the predicted frequency of a limit hit can assist in designing an optimal futures contract with regard to two issues the cost of trading and the construction of an optimal limit regime. Using a logit function, we present an initial attempt to estimate the probability of a price-limit hit given the following variables: the price-limit regime, the conditional volatility and the contract price level. The estimation procedure is applied to pork bellies and oats futures. The results imply that the logit model can be employed for predicting the expected limit-hit frequency. Our ndings indicate that there is an inverse relationship between the conditional probability for a limit hit and the limit size, whereas the volatility and the price level are positively correlated with the conditional probability for a limit hit. Our ndings also demonstrate the magnitude of the reduction in the limit-hit frequency resulting from a given increase in the price-limit size. 2013 Elsevier Inc. All rights reserved.

Article history: Received 28 January 2013 Received in revised form 30 May 2013 Accepted 24 June 2013 Available online 6 July 2013 JEL classication: G13 G12 G10 Keywords: Limit pricing Limit regime Limit-hit frequency Futures contracts

1. Introduction Many securities exchanges in countries such as the USA, Canada, Japan, and numerous countries in Europe and Asia adopt daily price limits in order to allow security prices to uctuate within a pre-specied range set by the securities exchange. Once the observed price hits the limit, the equilibrium price is not reached due to the limits. Trading, however, can continue at the limit price. The literature discusses some benets resulting from the limits mechanism. Price limits prevent irrational price uctuations, help guarantee the performance of contracts and reduce the cost associated with margin requirements. This mechanism has recently attracted more attention in the face of the recent global nancial crises, and was frequently activated during 2008 and 2009 in several countries. This paper extends the issue of the optimal design of contracts discussed in the literature, and provides further insight into the interdependence between the limit regime and the limit-hit frequency. We estimate the limit-hit frequency, dened as the ratio of the limit-hit

days to the total number of trading days, and demonstrate how this frequency, given a certain price-limit regime, can be used for designing an optimal contract with regard to two issues the cost of trading and the construction of an optimal contract. Another related issue, as yet unexamined in the literature, is the extent to which the expected frequency of a limit hit can be estimated given a certain price-limit regime. For a limit policy involving limit changes, the present study attempts to estimate the expected frequency of a limit hit for a certain limit regime by employing a logit regression employed widely in the nancial and economics literature.1 We introduce three applications of the logit-function estimation: (1) predicting the limit-hit probability of a new limit regime; (2) estimating the cost of trading; and (3) testing the inuence of the daily volatility and the contract price on the probability of a limit hit. The objective of this study, therefore, is to present an initial attempt for estimating the expected frequency of a limit hit using a logit function, and linking it to the design of an optimal contract. We apply the estimation model to two types of futures contracts: pork bellies futures

We would also like to thank the editor and anonymous referees for their comments and suggestions, and the seminar participants at Haifa University and Ben-Gurion University for their comments on an earlier draft of the paper. Remaining errors are our responsibility. Corresponding author at: School of Business, Haifa University, Haifa, 31905, Israel. Tel.: +972 4 8249192; fax: +972 4 8243194. E-mail address: yagil@gsb.haifa.ac.il (J. Yagil). 1057-5219/$ see front matter 2013 Elsevier Inc. All rights reserved. http://dx.doi.org/10.1016/j.irfa.2013.06.004

1 The logit function is widely used in a variety of research questions in nance such as contagion, trading activity and securities underwriting. Contagion: Bae, Karolyi, and Stulz (2003) evaluate contagion in nancial markets across countries, within a region, and across regions using a logistic regression model.

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traded on the Chicago Mercantile Exchange (CME) and oats futures traded on the Chicago Board of Trade (CBOT). Our two-contract sample is unique relative to prior works in terms of the duration of the sample (41 and 32 years of daily price quotes ending in July 2010 for pork bellies and oats, respectively) and the relatively high proportion of the limit hit observations. Our empirical ndings indicate that the logit function well predicts the limit-hit frequency for both the pork bellies and the oats contracts. The results conrm that the relationship between the probability of a limit-hit and the limit size, the volatility and the price level of the contract is statistically signicant. We nd an inverse relationship between the limit-hit probability and the size of the limit price, whereas the impact of both the contract price and the return volatility on the limit-hit probability is positive. By linking the logit function to the issue of optimal contract design, we nd that the cost of trading is negatively correlated with the limit size. These ndings can assist futures exchanges in setting an optimal limit size that minimizes trading costs given the volatility and the contract price. The remainder of this study is organized as follows. Section 2 reviews the literature. Section 3 discusses the effect of limits on returns. Section 4 outlines the methodology. Section 5 describes the data. Section 6 provides the results and discusses them. Section 7 presents the applications of the logit-function estimation, and Section 8 concludes the study.

2. Literature review The cost of trading issue was primarily examined by Brennan (1986). He states that an optimal contract is designed to minimize the total cost of participation in the market of a representative trader who takes a position in a single contract. He shows that price limits, in conjunction with margin requirements, may be useful in controlling the default risk. He also shows that for the representative trader the cost of trading for the optimal contract is a function of several parameters, including increased operating costs and illiquidity, as well as other costs associated with an excessive limit-hit frequency. These ndings are supported by Ackert and Hunter (1994). They nd that the optimal daily limit increases with interruptions in the cost of trading and decreases with running costs, which reect the expenses associated with providing continuous operation of the market. The issue of price limits has been investigated extensively in the literature. Price limits may serve as a partial substitute for margin requirements (Brennan, 1986), a nding later corroborated by Chowdhry and Nanda (1998). These results are true only when the trader's degree of risk aversion is low and the precision of additional information about the equilibrium futures price is also low (Chou, Lin, & Yu, 2005). Price limits reduce the sum of optimal clearing margin and capital to a level that is substantially lower than that required in the absence of price limits (Shanker & Balakrishnan, 2005). Price limits also insure implementation risk to some degree (Kodres & O'Brien, 1994). Stocks that have frequent limit hits have strong returns, high trading volumes, and receive more news coverage (Seasholes & Wu, 2007). Following an up-limit hit, the price usually continues to rise on the subsequent day (Park, 2000). While trading activity increases after either trading halts or price limits are invoked, volatility stays the same after trading halts but increases after price limit hits are reached (Kim, Yage, & Yang, 2008). A futures contract of a certain commodity can be traded in more than one market. The literature considers the part of the volatility in prices as a spill-over from other countries in which an identical contract is traded (at overlapping or different hours). Accordingly, several studies investigated the information transmission and price linkage across markets using similar futures contracts. The overall result is that volatility in prices is likely to reect global forces as markets become more integrated (see, e.g., Booth, Brockman, & Tse, 1998; Tse, 1998; Fung, Leung, & Xu, 2001; Holder, Pace, & Thomas, 2002).

Another question, dealt with in the literature, is whether price limits have a cooling off effect that stabilizes prices once they approach a limit (Ma, Rao, & Sears, 1989; Arak & Cook, 1997; Hall & Kofman, 2001; Abad & Pascual, 2007; Fernandes & Rocha, 2007), or a magnet effect that accelerates prices toward the limits (Holder, Ma, & Mallett, 2002; Belcher, Ma, & Mallett, 2003; Hsieh, Kim, & Yang, 2009). Kim (2001) shows that a change in the price-limit regime usually does not change the volatility of securities' returns. For volatile periods, earlier studies found that the S-shape relationship between observed and theoretical asset prices in markets governed by a price-limit mechanism may not exist (Hall & Kofman, 2001). Subsequent studies examined the conditions under which such a relationship may exist depending mainly on the differences in the extent of information available in the futures markets (Levy & Yagil, 2005). The literature has also tested a variety of models to determine the most effective ones. Brennan's (1986) original model was broadened to two periods (Chou, Lin, & Yu, 2000), and extended to investigate whether the imposition of spot price limits can further reduce the default risk (Chou, Lin, & Yu, 2003). Other examples of models include a censored stochastic volatility model to capture important features of a return series censored by price limits (Hsieh & Yang, 2009) and a Censored-GARCH model with price limits used to estimate the returngenerating process (Wei, 2002). Harel, Harpaz, and Yagil (2005) developed a Bayesian forecasting model in the presence of return limits and provided some numerical predictions. Researchers have found that the near-limit model performs better than ve other models proposed in the literature in its ability to predict returns (Levy & Yagil, 2006). Related works include the literature on circuit breakers and trading halts.2 Finally, in a recent study, in which a logit function has also been applied, Hsieh et al. (2009) study the magnet effect hypothesis. They observe that the closer the price gets to its upper (lower) limit, the greater is the probability that the price will move up (down) to reach the limit.

3. Price limit effects on returns A price limit is a mechanism that restricts the price at which an asset can be traded in a given time period to some range based on the asset's previous day (close) price. To better understand the impact of the limits on the return-generating process, the following framework is employed. Let P*t and r*t be the equilibrium price and return of a security on Day t. Suppose that a price limit rule exists which prevents the equilibrium price from being observed. Instead, the limited or censored price (Pt) is observed. The censoring allows the computation of the observed return on Day t (rt) only. The relation between the observed and the equilibrium returns can be described as follows: LnPt1 LLnPt rt rt LnPt1 LLnPt1 if if if Pt Pt1 N L L b Pt Pt1 b L Pt Pt1 b L

where L is the (dollar) price limit (henceforth the limit size). On a given trading day, if the equilibrium price change is between the up-hit and the down-hit limit ( L b P*t b L), the price limits are ineffective and the equilibrium return equals the observed return. If the

2 Subrahmanyam (1994), for example, argues that volatility increases when traders may sub-optimally advance their trades in anticipation of an impending price-limit hit. Trading activity: Grinblatt and Keloharju (2001) monitor the buying, selling, and holding of individuals and institutions in the Finnish stock market on a daily basis, and employ logit regressions to identify the determinants of buying and selling activities over a two-year period. Underwriting: Ng and Smith (1996) use a logit function to determine whether to include warrants as compensation to underwriters.

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equilibrium return is equal to or higher than the up-hit limit (r*t L), or if it is equal to or lower than the down-hit limit (r*t L), a limit price is determined. The observed price for the up-hit limit is Pt = Pt 1 + L, while the observed price for the down-hit limit is Pt = Pt 1 L. If the equilibrium return is between the up-hit and the down-hit limit, the observed price should equal the equilibrium price. If the equilibrium return is higher than the up-hit limit, or lower than the down-hit limit, a limit price is determined. The difference between the logarithm of the equilibrium price and the logarithm of the observed price on Day t (ln(P*t) ln(Pt)) is called the leftover. The leftover describes the price movement left over due to the price limit on Day t. Note that the leftover has no effect on the probability of a limit hit. On days when the equilibrium price equals the observed price (P*t = Pt), the leftover equals zero (LOt = 0). On up-limit hit days (P*t N Pt) the leftover is positive, whereas on down-hit limit days the leftover is negative. 4. Methodology We now present the methodology for estimating the limit-hit frequency by employing a logit function and using the individual data observations of the sample. 4.1.1. The Limit-hit frequency as a function of the limit size, price level and the volatility To test whether there is an inverse relationship between the limit size and the limit-hit frequency, we proceed as follows. Given a sample of N returns in N trading days, one can infer whether a limit hit had occurred on Day i (Yi). Given that the outcome is binary, it may be expressed by the values of one and zero: Yi 1 0 if Trading Day i is a limithit day : otherwise 2

such a linear model is likely to suffer from heteroskedasticity. A simple solution to this problem is to transform the probability, and estimate the (conditional) probability of a limit-hit day using logit regression. To avoid misspecication problems that may result in biased coefcients or heteroskedasticity, we added two explanatory variables: the price level of the contract (xi2) and the conditional volatility (xi3). We hypothesize that these two variables affect the probability function differently. On the one hand, the higher (lower) the volatility level, the greater (lesser) is the likelihood that the contract price will reach the limit. On the other hand, when the price level reaches higher values, the limit size in percentage terms becomes lower. Consequently, daily uctuations may seem negligible in terms of percents, but can exceed the limit price expressed in cents. Hence, we expect that xi2 should be positively correlated with the conditional probability. To estimate the limit hit probability given these variables, we employ the following logit equation which is estimated using the maximum likelihood method.

Pt;i 1=1 expab1 xi1 b2 xi2 b3 xi3 ;

where Pt,i is the probability that a limit-hit day of Trading Day t belongs to the i-th limit regime, and where P in this context is equivalent to in the Bernoulli distribution described in Eqs. (3), (4) and (5) above; a is an intercept; xi1 is the logarithm of the limit regime i; i.e., xi1 = ln(Li), where Li is Limit Regime i and xi3 is the conditional volatility in terms of the variance (2). Similarly, the probability for a no-limit hit day can be expressed as (1 Pt,i): 1Pt;i expaXB=1 expaXB; 7

We view yi as a realization of a random variable Yi that can take the values of one or zero with probabilities i and 1 i, respectively. The distribution of Yi is therefore a Bernoulli distribution with parameter i, and can be written as: PrfYi yi g i i 1i
y 1yi

for yi 0; 1:

where X is the explanatory variables (xi1, xi2, xi3), and B is the coefcients vectors (b1, b2, b3). For the third explanatory variable, i.e., the conditional volatility of the contract price (xi3), we initially follow McCurdy and Morgan (1987) and Morgan and Trevor (1999) and adopt a naive model to predict the rate of return on futures contract. It is based on a generalized autoregressive conditional heteroskedasticity GARCH(1,1) process (Bollerslev, 1986) and it is described as follows: rt t t ; t 0 1 t1 2 t1 ;
2 2 2

In our case, we suppose that the trading days can be classied according to the limit regime into k groups, in such a way that all trading days in a group have identical values of all covariates; a limit regime of 2 cents, 3 cents etc. Let ni denotes the number of observations in group i, and let Li denotes the limit regime. If the ni observations in each group are independent, and if they all have the same probability of being a limit hit (i), then the distribution of Yi is binomial with parameters i and ni. Formally: Yi ~ B(ni,i). The probability distribution function of Yi is given by:  PrfYi yi g  ni y n y i i 1i i i ; yi
y

8 9

for yi = 0,1,,ni. Here i i 1i ni yi is the probability of obtaining yi successes (namely, limit-hit days) and (ni yi) failures (namely, nolimit-hit days) in some specic order, and the combinatorial coefcient   ni is the number of ways of obtaining yi successes in ni trials. yi Assuming the existence of a relationship between the limit-hit probability (i) and the limit size (Li), we can estimate the following equation: i a bLi ; 5

where r*t is Day t equilibrium return and t is the Day t expected change in the security's equilibrium price; t is the error term; 2 t denotes the conditional variance of the security's return on Day t; and 0, 1 and 2 are the GARCH model coefcients derived from the maximum likelihood estimation. Several other asymmetric GARCH models that allow an asymmetry in both the conditional mean and variance equations within the models could be used as well for describing the volatility dynamics. The literature provides modied models such as those by Glosten, Jagannathan, and Runkle (1993) and Gonzalez-Rivera (1998), the sign- and volatility-switching ARCH (SVSARCH) model by Fornari and Mele (1997), the Markov switching volatility ARCH (MSVARCH) model by Hamilton and Susmel (1994) and the asymmetric nonlinear smooth-transition generalized autoregressive conditional heteroskedasticity (ANST-GARCH) model (Anderson, Nam, & Vahid, 1999; Nam, Pyun, & Avard, 2001).3

where Li is Limit Regime i, and a and b are the regression coefcients. Eq. (5) is sometimes called the linear probability model. However,

3 We would like to thank one of the two referees for the suggestion to incorporate these studies.

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T. Levy et al. / International Review of Financial Analysis 30 (2013) 141148 Table 1 Descriptive statistics for the estimation and prediction periods of pork bellies and oats futures. Pork bellies Number of trading days Average rate of return (%) Standard deviation Skewness Kurtosis Number of limit days Number of total limit days Limit proportion of total days (%) Number of up-hit limit days Limit proportion of up-hit days (%) Number of down-hit limit days Limit proportion of down-hit days (%) Trading volume average (Standard deviation) Open interest average (Standard deviation) 10,223 1853 0.0053 0.0266 2.1326 2.0198 0.4872 3.9833 58.6553 53.9247 1441 113 14.33 6.09 729 60 7.13 3.23 712 55 6.96 2.96 1020.49 969.62 3547.87 2625.04 Oats 7684 2480 0.0111 0.0588 1.9463 2.1675 0.1833 0.5165 5.7634 7.8483 117 14 1.52 0.56 61 6 0.79 0.24 56 8 0.72 0.32 1608.93 1069.54 12,411.2 3504.83

4.1.2. The limit-hit frequency as a function of the limit size and the previous day's price change We now estimate the limit-hit frequency as a function of the limit size as well as the previous day's limit hit. Following the same logic used to construct Eq. (6), we can estimate the following equation: Pt;i 1=1 expaXBcyt1 ; 10

where all notations are as dened above, and yt 1 is a dummy variable equal to 1 if Day t 1 is a limit hit, and 0 if it is a no-limit hit. The coefcients a, B = (b1, b2, b3), and c are the regression coefcients. 5. Data 5.1. Samples We used daily data on two futures contracts trading on two of the leading futures exchanges in the U.S. As in prior studies, we selected high-volume contracts.4 Specically, we used pork bellies futures traded on the Chicago Mercantile Exchange (CME), and oats futures traded on the Chicago Board of Trade (CBOT). The selection of the sample was based on three main criteria: (1) a change in the limit-hit regime for at least three times; (2) a limit-hit proportion that is relatively higher than that employed in prior studies; and (3) very long time series data to avoid biased results. Two contracts met these three criteria: pork bellies and oats. The pork bellies contract includes about 41 years of daily futures close prices (19702010), while the oats contract includes about 32 years (19792010). The data sets were taken from the exchanges' web sites.5 In keeping with earlier empirical studies of futures, we used only the nearby futures contract; namely, the futures contract that is closest to the spot delivery month, but not the delivery month itself. Over the last three decades the prices of the oats and pork bellies contracts have been approximately doubled. For example, the oats contract price on January 1980 was $155, while on January 2010 it amounted to $279. For the pork bellies contract, the price rose from $48.65 to $87.5 over the same period of time. This price change appears consistent with the change in the size of the price limit over time. 5.2. Descriptive statistics As noted above, the database for the two futures contracts (pork bellies and oats) covers a large period of time relative to those used in earlier price-limit studies.6 For each contract, the total number of trading days was divided between the estimation period and the prediction period as described below. We based this distinction on the question of whether past limit-hit frequencies could predict the limit-hit frequencies when a new regime was adopted. 5.2.1. Pork bellies During the last three decades, the CME has made three major changes in the price-limit regime of pork bellies futures. In 1975, it increased the daily price limit from 1.5 to 2 cents/lb (above or below the previous day's settlement price), and in 1996 it again increased

Notes: Table 1 describes the summary statistics of pork bellies and oats futures. The limit proportion is the ratio of the limit days to the total number of trading days (observations). For each row in the table, there are two lines of numerical values. The upper line represents the total period, and the lower (bold) line represents the prediction period. The descriptive statistics are based on daily rates of return.

the limits from 2 to 3 cents/lb. In March 2003, the CME adopted a gradual price-limit policy of 2, 3 and 4.5 cents. Therefore, we ended the estimation period in February 2003 and started the prediction period in March 2003 in order to test the prediction ability of the limit-hit frequency using the estimation period data. The prediction period ends on July 12, 2010. The regular daily price limit is set at the beginning of each calendar quarter, based upon the settlement price of the contract nearest to expiration on the last business day of the prior calendar quarter. If the contract nearest to expiration settles at a price below 60 cents/lb on that day, the regular daily price limit for all contracts will be 2 cents/lb for the following quarter. If the contract nearest to expiration settles at a price equal to or above 60 cents/lb on that day, the regular daily price limit for all contracts will be 3 cents for the following quarter. If the contract nearest to expiration hits the limit for two successive trading days, excluding the last trading day for the contract nearest to expiration, then, on the next business day, the daily price limit for all contracts is raised to 150% of the regular daily price limit applicable to that day.

See, e.g., Kodres (1993), Yang and Brorsen (1995) and Park (2000). The exchanges sites are: http://www.cme.com and http://www.cbot.com. 6 Arak and Cook (1997) use T-bond futures for 19801987. The time period covered by Morgan and Trevor (1999) is 19791982. Park (2000) covers the years 19861996. Hall and Kofman (2001), for example, use 227 trading days in 1988. Holder, Ma, et al. (2002) and Holder, Pace, et al. (2002) use corn and soybean contracts for the period 19941998. Levy and Yagil (2005) use two data sets 23 years of daily futures prices (19792002) and 795 days of daily data for common stocks (19992002). Finally, Chou (1999) and Harel et al. (2005) use only numerical simulations.
5

5.2.2. Oats Up until December 1982, the CBOT had set the price limit of oats at 6 cents. From January 1983 to August 25, 2000, the level was 10 cents.7 On August 26, 2000, the limit increased to 20 cents. We therefore made the estimation period end on August 25, 2000. The prediction period begins on August 26, 2000, and ends on July 12, 2010. Table 1 contains the descriptive statistics of the two futures contracts in our samples for both the estimation period and the prediction period. The total number of trading days for both the estimation and the

During this time period, the price limit sometimes changed by 50%.

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prediction periods for each of the two contracts is as follows: pork bellies 10,223 and oats 7684. The sample period of the pork bellies futures contract is January 1, 1970 to July 12, 2010. It includes 10,223 trading days, of which 8370 trading days belong to the estimation period and the remainder to the prediction period. The estimation period contains 1328 trading days that are price-limit-hit days, resulting in a limit-hit frequency of 15.86% (1328/8370). The limit proportion is dened as the ratio of the limit days to the total number of trading days. For the prediction sample, the pork bellies futures' closing price hits the limit 113 times, corresponding to a limit proportion of 6.09%. This proportion is generally higher than that in samples used in prior studies. In Kodres (1993), for example, the limit-hit frequency for the ve currency contracts studied is between 0.4% and 1.9%. In Morgan and Trevor (1999) it is about 7.3% (for treasury bill futures), and in Park (2000) the limit-hit frequency is between 0.7% and 2.7%, for corn, oats, soybean and wheat futures. The limit-hit frequency of the pork bellies contract in this study is therefore relatively high a feature that can allow a wider spectrum of robustness tests. The average daily rates of return for the two futures contracts during the estimation period and the prediction periods are as follows (in this order): pork bellies: 0.0053% and 0.0266%; and oats: 0.0111% and 0.0588%. The corresponding values for the standard deviation are: pork bellies: 2.132% and 2.0198%; and oats: 1.9463% and 2.1675%. According to Table 1, for the oats contract the mean trading volume is statistically higher, while the mean open interest is statistically lower than the corresponding value for the pork bellies contract. 6. Results The estimation results of Eqs. (6) and (10) for each of the two futures contracts are presented in Tables 2 and 3, respectively. Table 2 describes the following estimation results of Eq. (6): the coefcients, the number of observations, the log likelihood, McFadden's (1974)-R2 and the number of limit regimes. The results indicate that except for the intercept in Table 2 for pork bellies, the other coefcients in Tables 2 and 3 are statistically signicant. The negative signs of the b1 coefcient in these tables indicate that the limit-hit frequency decreases as the limit size increases. This nding ts our main hypothesis according to which limit hit probability is inversely related to the size of the limitprice. The coefcients b2 and b3 in Tables 2 and 3 are, as expected, positive and statistically signicant. Positive b2 implies that if the absolute price value of the contract rises up, it can contribute and increase the probability for a limit hit. This nding may explain why exchanges permanently update the size of the limit price along the time. For example, the limit size for oats futures contracts during the 1970's was 6 cents, but reached a value of 20 cents in 2010. Though the contract price

Table 3 The estimation results of Eq. (10) for the two futures contracts. Pork bellies a b1 b2 b3 C # observations Log likelihood Mc-R2 # limit regimes 0.543a 1.373a 0.0178a 13.112a 0.897a 8373b 4200.65 0.0715 3 Oats 9.050a 0.200a 0.0291a 71.452a 0.865a 5206 360.71 0.2871 4

Notes: The ndings in Table 3 are based on the estimation of the logit function illustrated in Eq. (10): Pt,i = 1 / (1 + exp( a XB cyt 1)). Mc-R2 is McFadden's (1974)-R2 statistic that is equal to (1 LL(a,b) / LL(a)), where LL(a,b) is the log likelihood of the estimated model and LL(a) is the log likelihood of the constant model. a Signicance level of 1%. b Signicance level of 5%.

rose only by 61% (from $161 to $260.25), the limit price rose by 233% (20 / 6 1). For pork bellies contracts, the limit-price in January 1970 was 1.5 cents, and during 2010 it can reach 4.5 cents (200%), whereas the contract price increased by 120% (from $48.65 to $87.5). Positive b3 implies that when the daily volatility is higher, the probability for a limit hit is greater. That is, when the volatility becomes higher, the price uctuations cause the price to be closer to the limit. The b3 coefcient in Tables 2 and 3 has relatively high values as a result of the low values of the conditional volatility (variance). The values of this explanatory variable range from 0.000112 to 0.00545 and from 0.00004 to 0.0362 for oats and pork bellies, respectively. For both contracts, as reported in Table 3, the coefcient C is positive and statistically signicant. This implies that the probability of a limit-hit increases when a limit-hit occurs in the previous trading day. This nding is in line with prior works. Park (2000) nds that following an up-limit hit, the price usually continues rising on the subsequent day. Furthermore, Kim et al. (2008) observe that the volatility increases after price limit hits are reached. The low Mc-R2 for the pork bellies contract can be related to a specication problem; i.e., the model may only include part of the potential explanatory variables. The estimation results of Eqs. (8) and (9) are reported in Table 4. Eq. (8) models the future's rate of return as a random-walk stochastic process, whereas Eq. (9) is the conditional variance equation with GARCH(1,1). Both equations are estimated together using the maximum likelihood function. Except for one coefcient, all the estimated coefcients are statistically signicant at the 1% level. We test for serial correlation in the squared-return series using the Ljung and Box (1978) test. Following prior works (e.g., Morgan & Trevor, 1999) we employ the statistic LB(k) for the lags k = 5

Table 2 The estimation results of Eq. (6) for the two futures contracts. Pork bellies a b1 b2 b3 # observations Log likelihood Mc-R2 # limit regimes 0.139a 1.621b 0.0213b 15.711b 8374 3978.45 0.053 3 Oats 9.550b 0.194b 0.0307b 81.230b 5206 363.76 0.2811 4

Table 4 Estimation results of Eqs. (8) and (9). Pork bellies 0 1 2 n LL LB(k = 5) LB(k = 10) 0.000421a 0.0000a 0.11583a 0.90337a 8374 18,959 4.35 6.91 Oats 0.000235 0.00001a 0.07861a 0.88633a 5205 13,711 4.65 11.39

Notes: The ndings in Table 2 are based on the estimation of the logit function illustrated in Eq. (6): Pt,i = 1 / (1 + exp( a XB)). Mc-R2 is McFadden's (1974)-R2 statistic that is equal to (1 LL(a,b) / LL(a)), where LL(a,b) is the log likelihood of the estimated model and LL(a) is the log likelihood of the constant model. a Signicance level of 5%. b Signicance level of 1%.

Table 4 presents the estimation results of Eqs. (8) and (9). Eq. (8) is the mean equation which predicts the daily rate of return of the futures contract allowing the conditional variance of the random disturbance to depend linearly on the past behavior of the squared errors as appears in Eq. (9). n is the number of observations and LL is the log likelihood function. LB is the Ljung and Box (1978) statistic which is employed to test for autocorrelation in the standardized squared residuals. a Signicance level of 5%.

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T. Levy et al. / International Review of Financial Analysis 30 (2013) 141148 Table 6 Robustness checks. Regime 6.1 Pork bellies 1 2 3 4 6.2 Oats 1 2 3 4 Limit (cents) 1.5 2 3 4.5 Observed limit-hit frequency (%) 21.16 16.84 7.44 0 Predicted limit-hit frequency (%) 22.58 16.23 7.88 3.64

and k = 10. These lags are used to control near and far serial correlations. Other lags we have employed yield qualitatively similar results. The null hypothesis of no serial correlation, as implied by the LB(k) statistic, is not rejected at the 5% level for both contracts indicating that the residual series do not exhibit conditional heteroskedasticity, and that the GARCH(1,1) type model applied is an appropriate specication. In order to explore how well each estimated logit function predicts the limit-hit frequency, we compare the observed limit-hit frequency and the predicted limit-hit frequency. The ndings in Table 5 are based on Eq. (6) modied to a logit form (Pt,i = 1 / (1 + exp( a b1Li))). They indicate that for the two contracts investigated, the estimation and prediction results were best for the pork bellies contract. As demonstrated by the results in Table 5, the observed limit-hit frequency and the predicted limit-hit frequency during the estimation period for the three regimes 1.5, 2, and 3 cents were as follows (in this order): 21.16% vs. 21.73%, 16.84% vs. 16.6%, and 7.44% vs. 9.28%. These ndings indicate that the logit model can be used for predicting the expected limit-hit frequency of the pork bellies contract. For the sake of robustness check and generality of the results, we employ also the results of Eq. (6) in its original form for the prediction window. The robustness check results are reported in Table 6, and they provide identical prediction ndings as reported in Table 5. In other words, the prediction works well along with the reduced and the extended form of the logit function illustrated by Eq. (6). For both contracts the overall results show that the frequency of a limit-hit decreases as the limit size increases for both the observed and the predicted frequencies. For oats, the gap between the observed and the predicted frequencies for the limit of 9 cents is due to the fact that there is one observation with a 9-cent limit, and for this single case no limit hit was observed. In spite of this described gap, the observed and the predicted limit-hit frequencies are still negatively correlated with the limit size. 7. Applications Two applications of the logit-function estimation will be introduced here: (1) predicting the limit-hit frequency of a new limit regime; and (2) estimating the cost of trading and testing the limit size effect on trader's cost of trading. 7.1. Predicting the limit-hit frequency of a new limit regime The estimation results of the logit function presented above can be useful for predicting the limit-hit frequency of a new regime adopted by an exchange. We illustrate this application for the pork bellies and oats contracts.

6 9 10 20

5.63 0.00 0.93 0.61

2.74 1.95 1.74 0.99

Notes: Table 6 describes the observed and predicted limit-hit frequencies for each of the two futures contracts during the estimation period. The ndings in Table 6 are based on the estimation results of the logit function reported in Table 2. The logit function is illustrated in Eq. (6): Pt,i = 1 / (1 + exp( a XB)).

7.1.1. Pork bellies In March 2003, the CME adopted a new limit regime for the pork bellies contract. According to this regime, there are three possible limits: 2, 3 and 4.5 cents. Of the total prediction period (March 1, 2004July 12, 2010), the limit regime of 3 cents existed for 1853 trading days, and the limit regime of 4.5 cents existed for only 7 days. Of the 1853 days, 113 were limit-hit days, equivalent to a limit-hit frequency of 6.1% (113/185). In contrast, none of the 7 days in which a limit regime of 4.5 cents existed were limit-hit days. This result is equivalent to an observed limit-hit frequency of 0%. As demonstrated by Table 5.1, the predicted limit-hit frequency is negatively related to the size of the limit regime. 7.1.2. Oats On August 26, 2000, the CBOT adopted a limit regime of 20 cents for the oats contract. During the prediction period, which starts on that day, both the predicted and the observed limit-hit frequencies are less than 1% (0.64% vs. 0.61%). 7.2. Estimating the cost of trading Suppose an exchange intends to launch a new futures contact. One of the methods for estimating the cost of trading of the new contract can be based on Brennan (1986) methodology. However, one of the parameters needed by that methodology is the probability that the limit will be reached. Using the estimation method described above, one can estimate that probability. The issue of the cost of trading was rst examined by Brennan (1986). He shows that price limits, in conjunction with margin requirements, may be useful in controlling the default risk. He also shows that for the representative trader the cost of trading of the optimal contract is a function of several parameters, among them, the limit-hit frequency. In this respect, the method for estimating the probability of a limit hit presented in this study can be employed for estimating the cost of trading of a given futures contract, and, consequently, for the design of an optimal contract. Brennan (1986) shows that the total cost of participation in the market for a representative trader, C(M,L), is given by: CM; L kM Pjrt j L=Pjrt j L; k; N 0 11

Table 5 The observed and predicted limit-hit frequencies during the estimation period. Regime 5.1 Pork bellies 1 2 3 4 5.2 Oats 1 2 3 4 Limit (cents) 1.5 2 3 4.5 Observed limit-hit frequency (%) 21.16 16.84 7.44 0 Predicted limit-hit frequency (%) 21.73 16.60 9.28 3.63

6 9 10 20

5.63 0.00 0.93 0.61

2.79 2.04 1.84 0.64

Notes: Table 5 describes the observed and predicted limit-hit frequencies for each of the two futures contracts during the estimation period.

where k is the opportunity cost of funds, k N 0; M is the (dollar) margin maintenance rate; kM is the cost of the margin maintenance. The expression P(|r*t| L) / P(|r*t| L) is the cost of the price limit. This cost, Brennan notes, is proportional to the ratio of the probability that the limit will be reached and no trading will take place, to the probability that the limit will not be reached.

T. Levy et al. / International Review of Financial Analysis 30 (2013) 141148 Table 7 The cost of trading. Regime 7.1 Pork bellies 1 2 3 4 7.2 Oats 1 2 3 4 5 none 6 9 10 15 20 0.00120 0.02991 0.02264 0.02073 0.01399 0.01044 none 1.5 2 3 4.5 0.00030 0.27793 0.19940 0.10284 0.03857 Limit (cents) Cost of trading (cents)

147

Notes: Table 7 describes the cost of trading for several limit regimes for each of the two contracts used in this study. The cost is calculated as in Brennan (1986): C(M,L) = kM + P(|r*t| L)/P(|r*t| L), k, N 0. Both tables demonstrate the negative relationship between the limit size and the cost of trading.

(2005) extend Brennan's model and suggest an optimal margin setting model. They show that there is a rational basis for price limits, in that they can reduce the sum of optimal margin and capital required to levels that are considerably lower than those required to minimize default risk in their absence. Their results indicate that the sum of capital and opportunity cost of optimal margin is approximately half of the corresponding values for the comparable model without price limits. As indicated by Table 7, the cost of trading in the case of no limits is 0.0003 and 0.0012 cents for pork bellies and oats, respectively; i.e., the cost is highest for oats. However, when price limits are present, the cost of trading for oats becomes the lowest. For example, the limit size as of the end of our sample period (July 12, 2010) is 3 and 20 cents for pork bellies and oats, respectively. For these limit sizes, the cost of trading, as indicated by Table 7, is 0.10284 and 0.01044 cents for the two contracts, respectively. The high limit size for oats accounts for its low cost of trading. This high limit size was caused merely by the quite few limit-hits during the oats prediction period (August 26, 2000 to July 12, 2010). This result seems consistent with Brennan's (1986) contention that price limits can serve as a partial substitute for margin requirements.

Table 7 presents the estimated cost of trading for each of the two futures contracts in our sample, using the values of 0.02% and 1 for k and , respectively. These two values were also used by Brennan (1986). The cost was calculated using the estimation results of Eq. (6) that appears in Table 2. For this purpose we estimate the logit function, described in Eq. (7), for each of the contracts. We begin with the pork bellies contract. 7.2.1. Pork bellies For pork bellies, the margin maintenance rate (M) is 3 cents/lb.8 The cost of trading ranges from 0.0003 cents (for the no limit regime) to 0.27793 cents (for the regime of 1.5 cents). The relation between the limit size and the cost of trading decreases from 0.27793 cents in the case of a limit size of 1.5 cents to 0.10284 cents in the case of a limit size of 3 cents. The majority of the cost can be attributed to the price limit size (0.27763 cents of the 0.27793 cents). The margin rate accounts for only a small portion of the cost (0.0003 cents). As noted in Table 5.1, the expected frequency of a limit hit P(|r*t| L) for a 3 cent regime is 9.28%. It then follows that the probability that the limit will not be reached, P(|r*t| L), is equal to 90.72% (19.28%). The cost of trading, therefore, is equal to: CM; L 0:02% 3 1 9:28% =19:28% 0:10284 cents: That is, for the parameter values given above, the cost of trading of the pork bellies futures contract is 0.10284 cents. This cost can be affected by a number of factors, including trading interruptions. 7.2.2. Oats For the oats contract, the margin maintenance rate (M) is 10 cents/lb. The cost of trading ranges from 0.02991 cents (for the 6 cents limit regime) to 0.01044 cents (for the regime of 20 cents). The ndings for oats, as reported in Table 7.2, support our hypothesis that raising limit size causes to lower the cost of trading. 7.3. A cost comparison of the two contracts The cost of trading, as noted by Brennan (1986), is due to both the limit size and the margin maintenance rate. Shanker and Balakrishnan

8. Summary and conclusions This study has presented a rst attempt to estimate the probability of a price-limit hit for a given price-limit regime. To achieve this goal, we have used a logit function. We have extended the issue of the optimal design of contracts discussed in the literature. We have demonstrated how, using a logit function and given a certain price-limit regime, an estimation of the limit-hit frequency can assist in designing an optimal contract with regard to two issues the cost of trading and the construction of an optimal limit regime. We have also investigated whether there is an inverse relationship between the limit size and the limit-hit frequency. We employed a sample consisting of about 17,907 daily prices over a period that ends in July, 12, 2010 for two futures contracts: pork bellies (41 years) and oats (32 years) traded on the Chicago Mercantile Exchange (CME) and the Chicago Board of Trade (CBOT), respectively. Given the low limit proportion for the oats contract, two features have made the pork bellies contract a more attractive sample choice: (1) its relatively high frequency of limit-regime change, and (2) its relatively high price limit-hit frequency. The overall estimation results indicate that the coefcients of the logit function are statistically signicant, and that the estimation gap between the observed and predicted values is negligible. The results of this study imply that the logit model can be employed for estimating the expected limit-hit frequency resulting from a given change in the limit size. Our ndings lend support to the hypothesis that there is an inverse relationship between the limit size and the probability of a limit-hit. Furthermore, the ndings show that daily volatility and the future contract price contribute to the increasing of the probability of a limit hit, a result that supports the magneteffect hypothesis. Two applications of the logit-function estimation have been introduced: (1) predicting the limit-hit probability of a new limit regime; and (2) estimating the cost of trading and employing the results in constructing an optimal limit regime. Correspondingly, we have presented two main results: (1) the estimation of a limit-hit frequency for a proposed limit regime; and (2) the employment of the estimation procedure for predicting the cost of trading. We have also shown that, as predicted by Brennan (1986), price limits can serve as a partial substitute for margin requirements. These ndings can be vital for futures exchanges in determining the optimal limit regime for a certain security. Future studies can investigate further how to determine an optimal limit regime given a desired level of a limit hit frequency.

8 According to the pork bellies contract specications, the trading unit is 40,000 lb, and the margin maintenance rate is $1200. The margin maintenance rate is therefore 3 cents/lb. According to the oats contract specications, the trading unit is 5000 bushels, and the margin maintenance rate is $500, resulting in a margin maintenance rate of 10 cents/lb.

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