In our last post on herding in the GCC markets which was published on December 28, 2011 on this blog [1], my co-authors Professor Mehmet Balcilar at East Mediterranean University in North Cyprus and Professor Riza Demirer at Southern Illinois University-Edwardsville, and I  highlighted the finding that the GCC markets have three volatility regimes (Low, High and Extreme or Crash) under herding. Our analysis also supports the view that herding in the GCC markets occurs during the worst volatility regime which is the extreme or crash regime. This finding calls on investors and traders in those markets to be cautious and more selective in choosing stocks, and on the GCC policy-makers to install safety nets that weather extreme market volatility. Market regulators should facilitate more transparencies in these markets and introduce sophisticated hedging techniques that protect investors during periods of extreme volatility. The well-informed foreign investors that understand fundamental analysis and prevent stocks from wandering too far from fair values should also be allowed to have direct ownership of stocks.

Further analysis of our results has detected more unusual herding behavior for the GCC stock markets. The three volatility regimes cycle in an abnormal way. It is known in the literature that regime transmission order in developed markets follows the sequence: Low, High and Crash, consecutively. Surprisingly, our analogous research on China has produced a regime transmission order similar to that of developed countries. In this case, investors in China and developed countries have enough warning during the high volatility regime that at the end of the tunnel a crash is coming. This signaling should therefore give those investors enough time to prepare and minimize the damage to their wealth or assets. However, in the GCC, the regime-transmission order cycles differently and dangerously. The order sequence is: Low, Crash and High volatility. This order does not give investors in those markets enough time to prepare because the crash comes fast and does not follow the High volatility. Moreover, after the crash, high volatility persists in the GCC markets which makes things worse.

To prepare for the swift onslaught of a crash, we put forth the following suggestion. The regime structure in the GCC offers market makers potential opportunities to create and sell new risk management products to GCC and foreign investors. One possibility is the selling/buying of crash options which can be structured similarly to the hurricane derivatives in the United States. The details of the crash options can be hammered out by the GCC regulators.

This new finding should reinforce our previous results about herding during the crash regime. It makes the case stronger for the necessity of making those markets less dangerous and safer. Our safety recommendations have found more support with the new finding.

[1] "Our Research on Herding in the GCC Markets: Astonishing Results".  http://www.zawya.com/blogs/shawkat.hammoudeh/111228063819/