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Rev Fin 1997; 10:837-869
© 1997 the Society for Financial Studies

Article

The threshold effect in expected volatility: a model based on asymmetric information

FM Longin
Department of Finance, ESSEC, Ecole Superieure des Sciences Economiques et Commericales, Avenue Bernard Hirsch-B.P. 105-95021 Cergy-Pontoise Cedex, France

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.


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