Price dynamics with circuit breakers

We model the dynamics of an asset price in the presence of a circuit breaker. A circuit breaker is a trading halt imposed by the exchange after the price drops below (or rises above) a pre-specified value within a trading session. The investors' anticipation of the probability of a halt feedbacks on the price process. In a general stochastic financial framework, this leads to coupled integral and stochastic differential equations. With first-order analytical solutions and numerical treatment, the theory predicts an increased price volatility prior to the trigger point, as has been reported in the empirical literature. We show that the sole existence of a circuit breaker leads to the adverse effect of attracting the price to the circuit breaker level (known as the ‘magnet effect’). We then propose first steps towards a more robust design of circuit breakers. In particular, we show that a trading halt that is conditioned on a pre-specified volatility level, instead of price level, mitigates the negative side effects of increased volatility. The methodology proposed in this article serves as starting point for the design of more resilient circuit breaker mechanisms.