Observed versus theoretical prices under price limit regimes

Theory predicts that in exchange-rate target-zone there exists an S-shape relation between observed and theoretical prices due to the credibility and intervention assumptions. Given the similarity between price limits and exchange-rate target-zone, we demonstrate that the credibility and intervention assumptions do not necessarily hold in markets regulated by price limits. Consequently, an S-shape relation between observed and theoretical prices may not always exist because a fundamentals shock known to all traders should yield a triangle-shape relation. Our study implies that the price-limit mechanism can have no effect (under a transitory shock), be stabilizing (under a fundamentals shock and information differentiation), or slow down the price-change pace (under a fundamentals shock and information homogeneity).