Professional Documents
Culture Documents
See Appendix-1
derivatives trading helps in price discovery, improves the market debt, enhances market
efficiency and reduces asymmetry information of spot market. This gives rise to the
controversy among the researchers, academicians and investors on the effect of
derivatives on the underlying market volatility and some selected reviews related to
equity futures and options are discussed in the following section.
With respect to futures trading, most of the studies are related to index futures due to lack
of trading in single-stock futures. Studies by Edwards (1988) on Value-line Index, Cahn
and Karlogi (1991) on Nikkei 225 Index, Leela and Ohk (1992) on Australian All
Ordinaries Index, Darrat and Raman (1995) and Kamara et al. (1995) on S & P 500 Index
4
See Appendix-1
found no significant changes in the volatility of the spot market. On the other side,
studies by Lockwood and Linn (1990) on DJIA Index, Brorson (1991), S & P 500 found
increase in the volatility of the spot market. A study by Gulen and Mayhew (2000) is
based on twenty-five countries. It found out an increase in volatility for S & P 500 and
Nikkei 225 indices, and all other countries showed no significant change in volatility.
Similarly, Ibrahim (1999) and Oliva and Armada (2001) did not find any significant
change on the spot market volatility of the Malaysia and Portuguese stock market
respectively. Butterworth (2000) found no significant change in the volatility of the
FTSE-250 index after onset of futures trading. Board, Sandmann and Surcliffe (2001)
show that, contrary to regulatory concern and the results of the other papers,
contemporaneous information less futures market trading has no significant effect on spot
market volatility. Some of the studies show a decrease in the volatility of the underlying
market. These studies include Bessembinder and Seguin (1992) on S & P 500 index,
Homes and Priestly (1998) on DAX 100 and Swiss MI index, Pierluigin Bologana and
Laura Cavallo (2002) on Italian Stock Market. In the case of options, most of the studies
are related to the individual stocks. It shows a decline in the volatility of the spot market
(Conrad 1989), Elfakhani and Choudhury (1995). Antoniou and Holmes (1995) found
that the introduction of stock index futures caused an increase in spot market volatility in
the short run while there was no significant change in volatility in the long run.
Number of studies has been carried out by different academicians to detect the spot
market volatility in case of India. One of the earlier studies by Thenmozhi (2002) showed
a decline in volatility of the spot market by examining S & P CNX Nifty index. Similar
results obtained by O.P. Gupta (2002), Raju and Karnde (2003) while Shengagaram
(2003) did not find any significant change in the spot market volatility. The Volatility of
the Nifty stock futures has been declined except for some stocks after the introduction of
futures. Further, the cash market volatility has also come down after the introduction of
the derivative market, but there are other reasons like microstructure changes and robust
risk management practices, which are responsible for the reduction in the volatility. (G.C.
Nath, 2003).
The above literature gives a mixed result about the effect of futures on the volatility of
the underlying market across the countries. The results depend on the indices and
methodology used in the study, because studies examine the same indices arrived at
different conclusions. Most of the studies are related to the developed countries like the
USA, the UK or Japan. But, a very few studies have been conducted in developing
countries like India. In this context, it gives rise to further research in this regard.
The present paper contributes in the following manner. Firstly, this paper seeks to
examine the behaviour of spot market by taking both closing and opening price returns
while most of the earlier studies in the Indian context based on the closing price returns.
Secondly, the present study employs GARCH technique to measure the volatility, and it
also explains the nature of the volatility before and after the introduction of futures and
options.
3. DATA SOURCES
The data for the study consist of daily closing and opening price returns of the S&P CNX
Nifty Index and Nifty Junior Index, which are collected from NSE. The data period is
taken from January 1, 1997 to March 31, 2005. S & P CNX Nifty is well-diversified 50
stocks accounting for 23 sectors of the economy. The data are colleted for closing and
opening prices. The total number of observations is 2065, out of which 857 and 1103
were prior to futures and options trading and remaining 1207 and 962 observations relate
to post-futures and options trading respectively. S&P CNX Nifty is owned and managed
by India Index Services and Products Ltd. (IISL), which is a joint venture of NSE and
CRISIL. This study is based on National Stock Exchange Data because 95 percent of the
trading in derivatives is done at NSE.
4. METHODOLOGY
The present scholarship is based on the stock index price returns. The daily returns based
on closing and opening prices were computed using the following equation.
Rt = Log (Pt / Pt-1)---------------------------------------------------(1)
The variance of the returns series is calculated to know the inter-day volatility by using
the following equation:
2 = ( Rt R )2 / T-1 --------------------------------------------(2)
Several scholars have carried out studies to show the volatility of the spot market before
and after the introduction of the futures trading. Hodgson (1991), Herbest (1992),
Thenmozhi (2002) etc. have measured the volatility by using standard deviation. Many
researchers like Kalok Chand (1991), Antonou and Holmes (1995), Gregory (1996),
Darren Butterworth (2000) use the GARCH model to overcome the problem of
hetroskedasticidy in the observed returns. The present study makes use of both the
methods to focus the volatility of the underlying market.
In order to determine whether the onset of futures trading has any effect on the
underlying spot market volatility, it is necessary to separate the volatility arising from
market wide factors other than futures trading. Previous studies have to filter out the
factors which lead to market wide volatility by regressing the spot market returns against
a proxy variable for which there was no related futures contract, { Antonium and Holmes
(1995), Kamara, et.al (1992), and Greoge, et. al.}. For Indian stock market, Nifty Junior
Index comprises stocks for which no futures contracts are traded. Thus, it serves as a
control variable for us to isolate market wide factors and thereby concentrates on the
residuals volatility in the Nifty as a direct result of introduction of index derivatives
contracts. To remove the effects of world wide price movements on the volatility of the
Nifty index returns, the lagged S & P 500 index returns has been take into consideration.
The futures trading is introduced as a dummy variable which takes the value 0 for prefutures and 1 for post-futures.
The co-efficient of the dummy variable determines the changes in the volatility of the
spot market. If it turns out to be negative, then there is a decline in the spot market
volatility with the inception of the futures trading and vice-versa. A zero coefficient
indicates no change in the volatility.
The assumption of classical linear regression model is that variance of errors are constant.
It is unlikely that in the context of stock returns data the variance of the errors will be
constant over time. Apart from these the OLS regression neglected the possible
autocorrelation in return and inherent time-varying nature of volatility, and it does not
allow one to explicitly capture the connection between information and volatility. Hence,
it is better to consider a model that allows the above limitations. Thus, the prime
motivations behind the development of conditional volatility models emanated from the
fact that the then existing linear-time series models were inappropriate. Hence, this study
makes use of non-linear models like ARCH.
Autoregressive Conditional Hetroscedastic (ARCH) model was first introduced by Engel
(1982), and it allows the conditional variance to change over the time. In ARCH model,
the variance is modeled as a linear combination of squared past errors of specific lag and
the autocorrelation in volatility modeled by allowing conditional variance of the error
terms, to depend on the immediately previous values of the squared errors.
An ARCH (P) can be specified as
t / t ~ ( 0, ht )
ht = 0 + 1 2 t -1 + .+ p 2 t p ----------------(3)
The ARCH model was generalized by Bollesla (1986), and it is called GARCH
(Generalised Autoregressive Conditional Hetroscadasticity). GARCH models explain
variance by two distributed lags: firstly, on past squared residuals to capture high
frequency effects or news about volatility from previous period measured as lag of the
squared residuals from mean equation, and secondly, on lagged values of variance itself
to capture long-term influences. A GARCH (p, q) model is given by the following
equation.
Yt = 0 + 1Xi + t -------------------------- (4)
t / t ~ ( 0, ht )
q
h t = 0 +
t 1
1 t-1 +
h
j 1
j t 1
vt
-----------(5)
in this case, P is the degree of ARCH, q is the degree of GARCH and Vt is the error term
with white noise process. The size of the parameters 1 and 1 determine the short-term
dynamics of the resulting volatility time-series. Large co-efficient of 1 shows that shocks
to conditional variance take a long time to cancel out, so volatility is persistence.
Secondly, the GARCH (1, 1) is estimated for measuring the volatility. The mean and
variance equation are as follows:
Rt at i Rt 1 t ---------------------------------------- (6)
ht a 1 t21 t21ht 1 2 D f 3 Do t ----------- (7)
Where Rt is daily return on the S&P CNX Nifty and Rt 1 is the lagged returns and in the
variance equation a dummy variable is introduced for futures and options. To eliminate
the effect of market wide factors in India and the world wide factors Nifty Junior Index
and S & P 500 Index is introduced in the mean equation. The equation is as follows:
Rt at i Rt 1 RtNiftyJunior Rt 1,S & P 500 t ---------------- (8)
5. EMPIRICAL DISCUSSIONS
The economic literature in the recent past has experienced an explosion of unit roots for
stationary of time series data as the choice of techniques and procedure for further
analysis and modeling of series depends on their order of integration. Hence, without
taking into account the presence of unit root in the variables, the analysis may produce
spurious results. Therefore, Augmented Dicky- Fuller and Philips-Perron unit root tests
are employed to test the integration of each variable. ADF unit root test is sensitive
towards the lag length included in the regression equation. Hence, the lag length is
chosen on Akaike Information Criterion (AIC). The result of the unit root test is shown in
Table 1. All the return series are stationary at its level and they are significant at 1 percent
level. The same can be seen from the graph which is given at the end of the paper.
Table: 1 Unit Root Results
Variable
With
Philips-Perron Test
Without
With
With
intercept
intercept
intercept
intercept
intercept
intercept
-19.7911
and trend
-19.7955
-45.28834
and trend
-45.28401
-45.28114
Nifty
-19.3742
-19.42265
-19.42368
-41.70323
-41.71917
-41.71391
Junior
S & P 500
-21.9375
-21.95832
-23.03165
-48.3199
-49.32953
-49.38179
Pre-Futures
0.00049
Post-Futures
0.00029
Pre-Options
0.00016
Post-Options
0.018559
Overall
0.000374
S.D.
(0.001083)
0.01894
0.000388
0.01453
(0.000346)
0.01855
(0.001011)
0.013800
(0.000667)
0.016509
(0.022374)
0.017443
(0.022490)
(0.015768)
Probability 0.00000
0.00000
0.00000
0.000
NOB
858
1207
1103
962
Note: Figures in the parenthesis indicate values for Nifty Junior.
(0.019642)
0.000000
2065
Table-2 provides the descriptive statistics for Nifty and Junior Nifty index returns. The
standard deviation was 0.1894 and 0.0185 for pre-futures and pre-options respectively.
But it has come down to 0.01453 and 0.013 for the same.
The objective of this paper is to see the effect of introduction of futures and options on
the volatility of underlying markets. An analysis is done to explain the same by
regressing the spot market volatility on Nifty Junior returns, S & P 500 Index and Nifty
futures and options by using GARCH technique. In order to overcome the problem of
classical linear regression models and comparison of results, the study uses non-linear
model, GARCH. Table-3 reports results obtained by using the equation 6 and 7 of
GARCH technique. It shows that Nifty Junior return is regressed against its lag value
using GARCH (1, 1) technique with futures trading as a dummy variable. The lag length
chosen is 5. The co-efficient of the dummy variable is -2.84E-05 for the closing price
returns, which is significant at 1 percent level. It indicates that introduction of futures
trading reduces the spot market volatility, but it has a very negligible impact. In the case
of opening price returns, the coefficient of the dummy variable is also negative i.e.
-2.69E-05. For options the dummies are -0.0000249 and -0.000241 for closing and
opening prices respectively, and both are significant at 1 percent level (Table-4).
4
5
6
0.146481
0.749047
-2.84E-05
0.184532
0.715988
-2.69E-05
11.01967
30.61710
-5.927439
10.74136
29.30478
-5.650780
4
5
6
0.134236
0.759885
-2.49E-05
0.175273
0.722494
-2.41E-05
11.39926
32.49142
-5.765881
10.64046
29.60119
-5.654850
Table 5: Impact of Nifty Futures & Options on the Spot Market (Garch 1, 1)
SL.
1
Variable
2
3
efficients
Constant
5.00E-05
S&P
CNX 0.049704
6.565649
2.054770
efficients
4.89E-05
0.037633
6.957923
1.683201
4
5
6
7
Nifty Index
ARCH 1
GARCH 1
F DUMMY
O DUMMY
10.43919
27.83160
-3.19716
-2.51474
0.179239
0.712030
-1.71E-05
-1.26E-05
10.36807
27.83012
-2.619723
-2.233087
0.141931
0.741486
-1.91E-05
-1.28E-05
Table-5 shows the results of the GARCH (1, 1) process of the S & P CNX Nifty after the
introduction of the nifty index futures and index options simultaneously. For futures and
options the co-efficient of the dummy variable is negative i.e. -1.91E-05 and -1.28E-05
respectively. Though the co-efficients of the dummies are significant at their respective
10
levels, these do not have any significant impact on the volatility of the spot market, which
is indicated by the low values of the options and futures dummies.
To remove the market wide factors Junior Nifty was introduced as a proxy variable in the
mean equation of the GARCH technique. The market wide factors are information news
releases relating to economic conditions like inflation rates, growth forecast, exchange
rate, monetary policy, etc. Further, there might be any change in the volatility due to the
world-wide market factors like change in the volatility of the US stock market. That is
why S & P 500 index has taken to capture the World wide fluctuations. The co-efficients
of the dummy variable is -2.94E-05 for closing price returns and -1.79E-06 for the
opening price returns for futures. Similarly, in the case of options, the co-efficients of the
dummies are -2.56E-05 and -2.00E-06 for closing price returns and opening price returns
respectively. After controlling the market-wide and world-wide factors, the coefficients
of dummies still remain negative, and are closer to zero indicating that it has a negligible
effect on the volatility of the spot market.
Table 6: Impact of Nifty Futures after Controlling Market Wide Factors
SL.
1
Variable
2
Constant
3
S&P CNX Nifty
4
5
6
7
8
Index
Junior Nifty
S & P 500
ARCH 1
GARCH 1
F DUMMY
0.067003
0.001368
0.150325
0.742966
-2.94E-05
0.685480
0.001214
0.093469
0.855002
-1.79E-06
3.778669
0.061603
10.58469
29.06139
-5.947178
92.93078
0.078232
7.795230
46.62763
-2.587291
Index
Junior Nifty
0.066731
0.687650
3.644826
11
93.17332
5
6
7
8
S & P 500
ARCH 1
GARCH 1
O DUMMY
-0.000873
0.137723
0.753913
-2.56E-05
-0.038314
10.94410
30.63286
-5.748425
0.013897
0.098601
0.845147
-2.00E-06
0.828292
7.907747
44.16185
-2.787367
Table-8 presents the results for Nifty index volatility after introduction of futures and
options simultaneously, thereby controlling market wide factors and world wide factors.
The futures dummies are -0.0000199 and -0.0000011 for closing and opening price
returns respectively. Similarly, the options dummies are -0.0000131 and -0.0000012
respectively for closing and opening prices. The sign of the co-efficients of the dummies
shows that volatility has declined in the post-derivatives segment, but it has a very little
impact on the underlying market.
Table 8: Volatility after controlling Futures and Options simultaneously
1
2
3
4
5
6
7
8
9
Index
Junior Nifty
S & P 500
ARCH 1
GARCH 1
F DUMMY
O DUMMY
0.686702
-0.024593
0.097386
0.845757
-1.10E-06
-1.25E-06
0.067406
0.001451
0.145774
0.734977
-1.99E-05
-1.31E-05
3.721878
0.063619
9.990090
26.32821
-3.273382
-2.543172
91.09954
-1.496204
7.742749
42.96302
-0.881796
-1.033443
To address the structure of the volatility after the introduction of futures, the whole period
is divided into pre-futures and post-futures. Similarly, for options the whole period has
been divided into options pre-options and post-options, and GARCH (1, 1) technique has
estimated separately for each sub-sample. This will allow us to compare the nature of the
volatility in each period. GARCH equation has two effects: one is ARCH effect and
second one is GARCH effect. ARCH is the coefficient of the square of the error term, and
shows the effect of recent news to the market whereas GARCH is the coefficient of the
lagged variance term and captures the effect of the old news in the market.
12
Table 9:
Volatility before and after the introduction of the futures (Closing Price returns)
Part-A
Parameters
Constant
Pre-Futures
2.25E-05
Post-futures
3.18E-05
Pre-Options Post-Options
2.74E-05
3.71E-05
ARCH (1)
(3.163719)
0.065162
(2.656031)
0.12237
(3.455743)
0.053302
(2.287125)
0.092624
GARCH (1)
(4.337653)
0.894716
(3.130740)
0.780181
(4.405131)
0.90285
(2.286776)
0.807116
(51.97215)
(32.18146)
(54.43926) (22.84734)
Volatility before and after introduction of the futures (Opening Price Returns)
Part-B
Parameters
Constant
Pre-Futures
4.68E-05
Post-futures
8.07E-05
Pre-Options
4.77E-05
Post-Options
1.02E-04
(3.873138)
(3.120490)
(4.141328)
(3.238615)
ARCH (1)
0.103590
0.093001
0.085160
0.131523
GARCH (1)
(6.033575)
0.863265
(4.015565)
0.805642
(6.030230)
0.876160
(4.386409)
0.739383
(40.69594)
(17.09872)
(44.34288)
(13.83962)
Part-A of the Table-9 reports the results of the structure of volatility in pre and postfutures regime. The estimates show that co-efficient ARCH was 0.06516 and 0.53302
before the introduction of the futures and options trading respectively and 0.12237 and
0.092624 after the introduction of the futures and options. It shows an increase in the
coefficient of the ARCH both in case of futures and options, which indicate that there is
an increase in the impact of the recent news on spot market volatility in the postderivatives phase. The co-efficient of the GARCH is 0.8947 in pre-futures and 0.90285 in
pre-options and declined to 0.78081 in post-futures and 0.807116 in post-options. It
indicates that the effect of the old news has declined in the post-futures period. Similarly,
Part-B of the Table-9presents the results of opening price returns. The GARCH coefficient shows a decline for both futures and options as in the case of closing price
returns. But, the ARCH co-efficient in the pre-futures was 0.1035 and it declined to
0.0930 in the post-futures. The overall results show that in the post futures and options
13
period, there has been an increase in the recent news to the spot market and at the same
time, a decline in the GARCH co-efficient shows that the impact of old news has
declined in the post-derivatives scenario. It may lead to the increase in the efficiency of
the market.
6. CONCLUSIONS
This paper examines the impact of futures and options trading in S & P CNX Nifty
futures contract on the underlying market using GARCH techniques. Further, it is based
on both closing as well as opening price returns. The results reported for the S & P CNX
Nifty index indicate that the existence of futures and options market made little impact on
the underlying level of volatility as measured by the GARCH technique for both closing
as well as opening price returns. The results of both closing and opening price returns for
futures explores that the surge of recent information to the stock market has increased
while the impact of the old news has declined in the post-derivatives scenario. A similar
result has been obtained for options as well. It indicates that the recent information
absorbs more rapidly than the old news in the stock market.
14
Appendix-1
Chronology of Events leading to Derivatives Trading in India
1956: Enactment of the securities contracts (Regulation) Act which prohibited all
options in securities.
May 2000: SEBI granted approval to NSE and BSE to commence trading of
derivatives
15
16
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