Nº 21-35: The Excess Volatility Puzzle Explained by Financial Noise Amplification from Endogenous Feedbacks

Puzzling deviations from the predictions of rational finance theory have been extensively documented empirically. In this paper, we offer an explanation for one of these anomalies, the “excess volatility puzzle”, i.e. the observation that prices fluctuate more than fundamentally justified. Based on Expectation Maximization (EM) calibrations of a generalized Hawkes point process model to price changes of major currency pairs and equity futures, we construct a decomposition of the variance of high frequency price changes into an exogenous (and thus efficient) component and an endogenous (and thus inefficient) excess component. The endogenously induced excess volatility is found to be substantial, largely stable at longer time scales and thus provides a plausible ex-planation for the excess volatility puzzle. Furthermore, strong endogenous variations at shorter scales are found to lead to major temporary inefficiencies. For example, during the “flash crash” in the GBP/USD exchange rate on October 7, 2016, we document a significant breakdown of market efficiency and an excessive burst in volatility, almost entirely explained by endogenous feedback. Conversely, the shock to EUR/ USD volatility in response to the 2016 Brexit referendum was not accompanied by such a deterioration in market efficiency. These results underline that a more solid understanding of the microstructural origins of financial fluctuations also bears important lessons for neo-classical concepts, like market efficiency, which are fundamental to financial and economic theory.